Life Cycle Costing
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A3 Get through intro So far, we have come across accounting systems which report costs and revenue by splitting them into time periods such as a month, a year, etc. This prevents consideration of the total profitability of an individual product or any other cost object and therefore does not allow the full picture to be seen. ‘Life-cycle costing’, on the contrary, traces all costs and revenue of a cost object (i.e., a product or service) from the stage of product planning to after sales service and ultimate abandonment and disposal (i.e., the period from ‘Cradle to Grave’). This Study Guide will help learners to understand the cost consequences of developing and manufacturing a product and to identify areas in which cost reduction efforts are likely to be most effective during the entire product life-cycle. You need to understand the concept of ‘life-cycle costing’ so that, as management accountants, you can find out and inform management whether the profits earned by a product during the manufacturing stage will be able to cover the costs incurred during the pre-manufacturing (development, design, etc.) and postmanufacturing stage (after sales service, product support, etc.) or not.
a) b)
Identify the costs involved at different stages of the life-cycle Explain the implications of life-cycle costing on pricing, performance management and decisionmaking
A3.2: Specific Cost And Management Accounting Techniques
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Introduction Let us look at an example to understand the concept of life-cycle costing. ‘Easy -accounting’ is an accounting software package which has a six year product life-cycle. The following are the year-wise costs estimated during its life-cycle: Cost Items
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
$
$
$
$
$
$
Production costs
115,000
202,000
85,000
Marketing costs
150,000
210,000
135,000
50,000
12,000 5,000
20,000 20,000
8,500 45,000
5,000 55,000
Research & Development costs
280,000
Design costs
125,000
Distribution costs Customer-service costs
The life-cycle costs for the ‘Easy-accounting’ package are as follows: Life-cycle costs
$
Research & Development costs
280,000
Design costs
125,000
Production costs
402,000
Marketing costs
545,000
Distribution costs Customer-service costs Total Life-cycle costs
45,500 125,000 1,522,500
It clearly takes into consideration the costs of the package incurred during the entire life-cycle. Accordingly, from life-cycle costing, the management can know whether the revenue earned by the product is sufficient to cover the whole costs incurred during its life-cycle. When viewed as a whole, there are opportunities for cost reduction and minimisation (and thereby scope for profit maximisation) whereas these are unlikely to be found when management focuses on maximising profit on a period–by-period basis. In this Study Guide, we will find out about the costs involved at different stages of the life-cycle and the implications of life-cycle costing on pricing, performance management and decision-making.
1. Identify the costs involved at different stages of the life-cycle [Learning outcome a] The term ‘life-cycle costing’ encompasses both the concepts of ‘product life-cycle cost’ and ‘customer lifecycle cost’. 1.1 Conceptualising ‘product life-cycle’ 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. It is launched; it grows and may, at some point of time, die. The progression of a product through these stages is however, not certain. Some products seem to stay in one stage forever (e.g. milk).
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Life-Cycle Costing: A3.3
A product life-cycle may be classified into three broad stages. Each of the stages include at least one of the business functions namely, Research and Development, Design, Production, Marketing, Distribution and Customer service. The stages of a life-cycle are: 1. The planning and design stage. This stage includes the following business functions: a) Research and Development b) Design 2. The manufacturing and sales stage. This stage includes the following business functions: a) Production b) Marketing c) Distribution 3. The service and abandonment stage. This stage includes the following business functions: a) After sales service b) Disposal of production facility Diagram 1: Identify the business functions involved at different stages of a product life-cycle
1.2 Costs committed and costs incurred 1.
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 are termed committed costs.
Studies show that about 80% of the life-cycle costs of a product are committed at its planning and design stage. It is difficult to significantly alter costs after they have been committed. Example The planning and design stage of a product determines its material and labour inputs and the production process. At this stage, costs become committed and broadly determine the future costs that will be incurred during the manufacturing stage. 2.
Costs are incurred when a resource is used or sacrificed. The actual cost of a product is built up mostly in the manufacturing stage and in the service and abandonment stage. Costs incurred vis-à-vis the costs committed at different stages of the product life-cycle are compared in the following diagram:
A3.4: Specific Cost And Management Accounting Techniques
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Diagram 2: Comparison of costs committed and cost incurred in product life-cycle stages
Stages of product life-cycle 1.3 Costs involved at different stages of product life-cycle For each of the business functions at each stage of life-cycle of each product, costs keep on being incurred. Let us try to identify the possible costs at each stage of the life-cycle: 1.
At the planning and design stage: Research and Development cost, Costs of product design, etc.
2.
At the manufacturing stage: This stage witnesses both growth and maturity in sales. All the manufacturing, marketing, selling and distribution costs are incurred at this stage.
3.
At the service and abandonment stage: This last stage of the product life-cycle is signified by a decline in sales volume. The demand for the product declines at this stage. The producers may be required to provide after sales service for the already sold products. Costs that are incurred in this stage include all costs relating to after sales service including provision of spares and expert services and costs of abandonment and disposal of the product.
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. Diagram 3: Time frame of a typical Product Life-Cycle Cost
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Life-Cycle Costing: A3.5
1.4 Conceptualising customer life-cycle costing A different notion of life-cycle costs is customer life-cycle costs. Customer life-cycle costs include the total costs incurred by a customer to acquire and use a product or service until it is replaced. Customer life-cycle costs for a car, for example, include the cost of car itself plus the costs of operating and maintaining the car less the disposal price of the car. Customer life-cycle costs can be an important consideration in the pricing decision. The best way to understand customer life-cycle costing is to look at an example. Example Suppose you are shopping for a new water heater. One costs $50 more than the other, but is better insulated and has a lower operating cost. Let’s assume they can both last ten years. It is observed that if one costs $25 more per year to operate, that difference amounts to $250 over the ten years. If we discount those savings back to today and also consider the current inflation rate, it is worth about $200 today. Since that is much more than the purchase cost difference, an initial investment of $50 is worth it from your point of view as a consumer. On the other hand, the manufacturer of the better insulated variety of water heater may think of increasing its product price considering its much advantageous customer life-cycle cost. SYNOPSIS Costs involved at different stages of life-cycle
2. Explain the implications of life-cycle costing on pricing, performance management and decision-making [Learning outcome b] 2.1 Implications of life-cycle costing on pricing Most accounting systems report revenue, costs and profit on a periodic basis, and product profits are not monitored over their life-cycle. A failure to trace all costs of products over their life-cycle hinders management’s understanding of product profitability, because a product’s actual life-cycle profit is unknown. Life-cycle costing estimates and accumulates costs over a product’s entire life-cycle so as to determine whether the profits earned during the manufacturing phase will cover the costs incurred during the pre- and postmanufacturing stages. To estimate the life-cycle costs it is essential to identify the costs incurred through different stages of life-cycle of a product. Only on knowing the life-cycle costs of a product, can one appropriately decide on its price. Moreover, if viewed from the angle of customer life-cycle costs, the life-cycle costs provide input for pricing across the lifecycle. Example An automobile manufacturer’s aim is to design cars that would minimise maintenance cost. The company expects to charge a higher price and / or gain greater market share by selling these cars. Similarly, manufacturers of washing machines and dishwashers charge higher prices for models that save electricity and have low maintenance costs. 2.2 Implications of life-cycle costing on performance management Life-cycle costing helps management to understand the cost consequences of developing and making a product and to identify areas in which cost reduction efforts are likely to be most effective.
A3.6: Specific Cost And Management Accounting Techniques
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Since life-cycle analysis highlights the committed costs of a product, it is possible, through emphasis on product planning, product design and development, to reduce product cost during its life-cycle. Life-cycle costing forms an input to evaluation processes such as value management, economic appraisal and financial appraisal. The old proverb, ‘time is money’, still holds true. The management of time is immensely important if the profit of a product is to be maximised. The management of time is particularly emphasised in life-cycle costing. Since a reduction in time during the development stage causes a decrease in cost or an increase in revenue, it in turn causes an increase in profit. 2.3 Implications of life-cycle costing on decision-making The importance of life-cycle costing lies in the consideration of the whole life-cycle. Life-cycle costing provides a long-term picture of product profitability, feedback on the effectiveness of initial planning and cost data to clarify the economic impact of alternatives chosen in the design, engineering phase etc. It is also considered a way to enhance the control of manufacturing costs. When viewed as a whole, cost reduction and minimisation opportunities as well as revenue extension opportunities will present themselves. It provides premises for decision-making regarding product introduction, product mix and regarding discontinuation of the products. SYNOPSIS
Quick Quiz 1.
What is meant by the term ‘product life-cycle costing’?
2.
What is meant by the term ‘customer life-cycle costing’?
3.
State the concept of the ‘committed cost’
4.
Briefly state the stages of a ‘product life-cycle’
5.
Briefly describe the implications of life-cycle costing on performance management
Answer to Quick Quiz 1.
Product life-cycle costing estimates and accumulates costs over a product’s entire life-cycle (sometimes a span of several calendar periods). It helps to identify whether the profits earned during the manufacturing stage will cover the costs incurred during the pre- and post-manufacturing stages.
2.
Customer life-cycle costing involves calculating the total costs incurred by a customer to acquire and use a product or service until it is replaced. Customer life-cycle costs for a car, for example, include the cost of car itself plus the costs of operating and maintaining the car minus the disposal price of the car.
3.
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 are termed committed costs (e.g. depreciation of any non-current asset)
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Life-Cycle Costing: A3.7
A product life-cycle may be classified into three broad stages. Each of the stages includes at least one of the business functions namely, Research and Development, Design, Production, Marketing, Distribution and Customer service. The stages of a life-cycle are: (a) The planning and design stage. This stage includes the following business functions: i. ii.
Research and Development Design
(b) The manufacturing and sales stage. This stage includes the following business functions: i. Production ii. Marketing iii. Distribution (c) The service and abandonment stage. This stage includes the following business functions: i. ii.
After sales service Disposal of production facility
5. Life-cycle costing helps management to understand the cost consequences of developing and making a product and to identify areas in which cost reduction efforts are likely to be most effective. Since life-cycle analysis indicates the committed costs of a product, it is possible, through emphasis on product planning, product design and development, to reduce product cost during its life-cycle. Life-cycle costing forms an input to evaluation processes such as value management, economic appraisal and financial appraisal.
Self Examination Questions Question 1 Futuristic Software Inc, a computer software company is developing a new accounting package, “Future Accounting”. The following are the budgeted amounts for Future Accounting Package over a six-year product life-cycle. Year 1 and 2 Research and Development costs Design costs
Year 3 to 6
Production costs Marketing costs Distribution costs Customer-service costs
$ 360,000 240,000
One-Time Setup Costs $ 150,000 105,000 75,000 120,000
Variable Cost per package $ 37.50 36 24 45
To be profitable, Futuristic Software Inc must generate revenues to recover costs of all six-business functions taken together and, in particular, its high non-production costs. Futuristic Software Inc wants to decide between three alternative selling prices i.e., $350, $430 and $550, so as to maximise life-cycle operating income. Sales volumes at these prices have been estimated at 7,500 units, 6,000 units and 3,750 units respectively. Identify which option maximises life-cycle operating income.
A3.8: Specific Cost And Management Accounting Techniques
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Question 2 Ace-soft Technologies Plc is examining the profitability and pricing policies of three of its recently developed software packages:
Electrical Genius: package for electrical engineers Mechanical Genius: package for mechanical engineers Industrial Genius: package for industrial engineers
Summary details on each package over their two-year “cradle-to-grave” product lives are as follows: Number of units sold Package
Selling Price $
Electrical Genius Mechanical Genius Industrial Genius
Year 1
Year 2
235
2,.150
8,100
285
2,200
3,150
185
5,100
3,700
Assume that no inventory remains on hand at the end of year 2. Ace-soft Technologies is deciding which product lines to emphasise. In the past two years, profitability has been mediocre. Ace-soft Technologies is particularly concerned with the increase in R & D costs. An analyst pointed out that for one of its most recent packages (Industrial Genius), major efforts had been made to reduce R &D costs. The engineering software manager decides to collect the following life-cycle revenue and cost information for the Electrical Genius, Mechanical Genius and Industrial Genius packages: Electrical Genius
Mechanical Genius
Industrial Genius
Year 1 $ 505,250
Year 2 $ 1,903,500
Year 1 $ 627,000
Year 2 $ 897,750
Year 1 $ 943,500
Year 2 $ 684,500
R & D cost
760,000
0
495,000
0
215,000
0
Design of product
215,000
25,000
115,000
7,750
83,500
12,000
55,250
221,000
90,000
90,000
162,000
54,000
155,000
395,000
132,000
153,000
224,000
198,000
Distribution
19,000
66,500
23,000
33,000
58,000
35,000
Customer service
45,000
270,000
33,000
99,000
202,000
322,000
Revenues Costs:
Manufacturing Marketing
Required: (a) How does a product life-cycle income statement differ from a conventional income statement? What are the benefits of using a product life-cycle reporting format? (b) Present a product life-cycle income statement for each software package. Which package is the most profitable, and which is the least profitable? Ignore the time value of money. (c) How do the three software packages differ in their cost structure (the percentage of the totals costs in each cost category)? Question 3 Donald products make digital cameras. Donald is preparing a product life-cycle budget for a new digital camera, DC3. Development on the new digital camera is to start shortly. Estimates for DC3 are as follows:
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Life-Cycle Costing: A3.9 $ 800,000 80
Life-cycle units manufactured and sold Selling price per camera Life-cycle costs: R & D and design costs Manufacturing: Variable cost per camera Variable cost per batch No. of batches Fixed costs Marketing: Variable cost per camera Fixed costs Distribution: Variable cost per batch No. of batches Fixed costs Customer-service costs per camera
2,000,000 30 1,200 1,000 3,600,000 6.40 2,000,000 560 320 1,440,000 3.00
Ignore the time value of money. Required: (a) Calculate the budgeted life-cycle operating income for the new digital camera. (b) What percentage of the budgeted total product life-cycle costs will be incurred by the end of the R & D and design stages? (c) An analysis reveals that 80% of the budgeted total product life-cycle costs of the new digital camera will be committed at the R & D and design stages. What are the implications for managing DC3’s costs? (d) Donald’s Market Research Department estimates that reducing DC3’s price by $6 will increase life-cycle unit sales by 10%. If unit sales increase by 10%, design plans to increase manufacturing and distribution batch sizes by 10% as well. Assume that all variable costs per camera, variable cost per batch, and fixed costs will remain the same. Should Donald reduce DC3’s price by $6? Show your calculations.
Answers to Self Examination Questions Answer 1 Statement showing comparison of alternative life-cycle revenue, life-cycle costs and life-cycle operating income
Selling price per package Sales quantity in units
Alternative Selling Price/ Sales-Quantity Combination A B C $350 $430 $550 7,500 6,000 3,750
A. Life-cycle revenues B. Life-cycle costs : R & D costs Design cost of product/ process Production costs (w1) Marketing costs (w2) Distribution costs (w3) Customer-service costs (w4)
$2,625,000
$2,580,000
$2,062,500
$360,000 $240,000 $431,250 $375,000 $255,000 $457,500
$360,000 $240,000 $375,000 $321,000 $219,000 $390,000
$360,000 $240,000 $290,625 $240,000 $165,000 $288,750
Total life-cycle costs C. Life-cycle operating income (A - B)
$2,118,750 $506,250
$1,905,000 $675,000
$1,584,375 $478,125
A3.10: Specific Cost And Management Accounting Techniques
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Clearly, alternative B with a selling price per package of $430 and a sales volume of 6,000 units yields the highest operating income. Workings 1. Production costsFor A, $150,000 + (7,500 units x $37.50/package) = $431,250 For B, $150,000 + (6,000 units x $37.50/package) = $375,000 For C, $150,000 + (3,750 units x $37.50/package) = $290,625 2. Marketing CostsFor A, $105,000 + (7,500 units x $36/package) = $375,000 For B, $105,000 + (6,000 units x $36/package) = $321,000 For C, $105,000 + (3,750 units x $36/package) = $240,000 3. Distribution costsFor A, $75,000 + (7,500 units x $24/package) = $255,000 For B, $75,000 + (6,000 units x $24/package) = $219,000 For C, $75,000 + (3,750 units x $24/package) = $165,000 4. Customer-service costsFor A, $120,000 + (7,500 units x $45/package) = $457,500 For B, $120,000 + (6,000 units x $45/package) = $390,000 For C, $120,000 + (3,750 units x $45/package) = $288,750 Note Life-cycle costs provide useful information for strategically evaluating pricing decisions. While calculating life-cycle revenue and life-cycle costs, it may be noted that calculation of annual revenue or annual cost is meaningless. Here, the revenue and the costs for the entire life-cycle of the product will have to be considered. Again, in annual accounts, the non-production costs such as Research and development cost and Design cost are normally considered as deferred cost and are amortized during the useful life of the product. But, so as to know the life-cycle revenue and costs of the product, one needs to consider revenue and costs for the whole life-cycle. Answer 2 (a) Difference between a product life-cycle income statement and a conventional income statement A product life-cycle income statement considers all revenue earned and all costs incurred during the lifecycle of a product. The life-cycle of the product may span a number of years. On the other hand, in a conventional accounting system, income statements are prepared periodically, i.e. product costs and revenues are reported period-wise. This prevents consideration of the total profitability of an individual product or any other cost object and does not allow the full picture to be seen. Moreover, the life-cycle costs will include the research and development cost and the design cost. In contrast, in a conventional accounting system, the non-production costs such as research and development cost and design cost are normally considered to be deferred costs and are amortized during the useful life of the product. The benefits of using a product life-cycle reporting format: Life-cycle costing provides a long-term picture of product profitability, feedback on effectiveness of initial planning and cost data to clarify the economic impact of alternatives chosen in the design, engineering phase etc. It is also considered a way to enhance the control of manufacturing costs. When viewed as a whole, cost reduction and minimisation opportunities as well as revenue extension opportunities will present themselves. It provides premises for decision-making regarding product introduction, product mix and regarding discontinuation of the products.
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Life-Cycle Costing: A3.11
(b) Alhough not desired in the problem, a conventional income statement has been prepared so as to show the difference between the conventional income statement and the product life-cycle income statement Step 1 Prepare the conventional income statement Conventional Income Statement
Revenues Costs: R & D cost Design of product Manufacturing Marketing Distribution Customer service Total cost Net operating income
Electrical Genius Year 1 Year 2 $ $ 505,250 1,903,500
Mechanical Genius Year 1 Year 2 $ $ 627,000 897,750
Industrial Genius Year 1 Year 2 $ $ 943,500 684,500
760,000 215,000
0 25,000
495,000 115,000
0 7,750
215,000 83,500
0 12,000
55,250 155,000 19,000
221,000 395,000 66,500
90,000 132,000 23,000
90,000 153,000 33,000
162,000 224,000 58,000
54,000 198,000 35,000
45,000 1,249,250
270,000 977,500
33,000 888,000
99,000 382,750
202,000 944,500
322,000 621,000
(744,000)
926,000
(261,000)
515,000
(1,000)
63,500
Step 2 Prepare the product life-cycle income statement Product Life-Cycle Income Statement
Electrical Genius
Mechanical Genius
Industrial Genius
$ 2,408,750
$ 1,524,750
$ 1,628,000
R & D cost
760,000
495,000
215,000
Design of product
240,000
122,750
95,500
Manufacturing
276,250
180,000
216,000
Marketing
550,000
285,000
422,000
85,500
56,000
93,000
315,000
132,000
524,000
2,226,750
1,270,750
1,565,500
182,000
254,000
$62,500
Revenues Costs:
Distribution Customer service Total cost Net operating income (for the life-cycle)
From the life-cycle net operating income, it is apparent that ‘Mechanical genius’ is the most profitable package. On the other hand, ‘Industrial Genius’ is the least profitable package.
A3.12: Specific Cost And Management Accounting Techniques
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Workings Electrical Genius Year 1 Year 2 $ $ A. Revenues B. Costs: R & D cost Design of product Manufacturing Marketing Distribution Customer service Total cost C. Net operating income (A – B)
Total $
505,250
$1,903,500
$2,408,750
760,000 215,000 55,250 155,000 19,000 45,000
0 25,000 221,000 395,000 66,500 270,000
760,000 240,000 276250 550,000 85,500 315,000
1,249,250
977,500
2,226,750
(744,000)
926,000
182,000
Mechanical Genius Year 1 Year 2 $ $
Total $
A. Revenues B. Costs: R & D cost Design of product Manufacturing Marketing Distribution Customer service
627,000
897,750
1,524,750
495,000 115,000 90,000 132,000 23,000 33,000
0 7,750 90,000 153,000 33,000 99,000
495,000 122,750 180,000 285,000 56,000 132,000
Total cost
888,000
382,750
1,270,750
(261,000)
515,000
254,000
C. Net operating income (A – B)
Industrial Genius Year 1 Year 2 $ $ A. Revenues B. Costs: R & D cost Design of product Manufacturing Marketing Distribution Customer service Total cost C. Net operating income (A – B)
Total $
943,500
684,500
1,628,000
215,000 83,500 162,000 224,000 58,000 202,000
0 12,000 54,000 198,000 35,000 322,000
215,000 95,500 216,000 422,000 93,000 524,000
944,500
621,000
1,565,500
(1,000)
63,500
62,500
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Life-Cycle Costing: A3.13
(c) The cost structures of different software packages are displayed below in percentage terms Electrical Genius Costs ($)
%
Mechanical Genius Costs ($) %
Industrial Genius Costs ($) %
Planning and design costs R & D cost Design of product
760,000 240,000
34.13 10.78
495,000 122,750
38.95 9.66
215,000 95,500
13.73 6.10
Manufacturing and sales cost Manufacturing Marketing Distribution
276,250 550,000 85,500
12.41 24.70 3.84
180,000 285,000 56,000
14.16 22.43 4.41
216,000 422,000 93,000
13.80 26.96 5.94
Service and abandonment cost Customer service Total
315,000 2,226,750
14.15 100
132,000 1,270,750
10.39 100
524,000 1565,500
33.47 100
Answer 3 (a) Product Life-cycle Income Statement Particulars
$
Life-cycle units manufactured and sold Selling price per camera A. Life-cycle revenue B. Life-cycle costs: R & D and design costs Manufacturing (w1) Marketing (w2) Distribution (w3) Customer-service costs (w4) Total Life-cycle costs
800,000 80 64,000,000
C. Life-cycle operating income (A - B)
22,060,800
Workings 1. Total Manufacturing Cost: Fixed cost Variable cost of camera (800,000 cameras x $30/camera) Variable cost of batch (1000 batches x $1,200/batch) Total
= $3,600,000 = $24,000,000 = $1,200,000 = $28,800,000
2. Total Marketing Cost: Fixed cost = $2,000,000 Variable cost of camera = $5,120,000 (800,000 cameras x $6.40/camera) Total = $7,120,000
2,000,000 28,800,000 7,120,000 1,619,200 2,400,000 41,939,200
A3.14: Specific Cost And Management Accounting Techniques
3. Total Distribution Cost: Fixed cost Variable cost of batch (320 batches x $560/batch)
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= $1,440,000 = $179,200 Total
= $1,619,200
4. Total Customer-service Cost: (800,000 cameras x $3.00/camera)
= $2,400,000
(b) The percentage of the budgeted total product life-cycle costs that will be incurred by the end of the R & D and design stage is = (R & D and design cost/Total product life-cycle costs) x 100 = (2,000,000/41,939,200) x 100 = 4.77%. Note Although the costs committed at the Research and Development and design stage are normally 80% (approximately) of the budgeted total product cost, the actual costs incurred are only 4.77%. (c) It had been revealed that the committed costs at the R & D and design stage for the product DC3 were 80% of the total budgeted costs. This implies that the R & D and design stage itself determines what the manufacturing cost of the product will be. If an appropriate product design is made by employing the techniques of value engineering, the actual costs in the subsequent stages of the product life-cycle can be greatly reduced. To manage DC3’s costs, it is necessary in the design stage to identify the product features which are non-value added and accordingly to curtail these features. (d) If the price of DC3 is reduced by £6, The proposed selling of the product will be $ (80 – 6) = $74 Accordingly, the quantity sold will increase by 10%, i.e., number of units to be sold during the life-cycle will be 800,000 x 110% = 880,000 units. Batch size would also increase to $1,100.
a) b)
Identify the costs involved at different stages of the life-cycle Explain the implications of life-cycle costing on pricing, performance management and decisionmaking
A3.2: Specific Cost And Management Accounting Techniques
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Introduction Let us look at an example to understand the concept of life-cycle costing. ‘Easy -accounting’ is an accounting software package which has a six year product life-cycle. The following are the year-wise costs estimated during its life-cycle: Cost Items
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
$
$
$
$
$
$
Production costs
115,000
202,000
85,000
Marketing costs
150,000
210,000
135,000
50,000
12,000 5,000
20,000 20,000
8,500 45,000
5,000 55,000
Research & Development costs
280,000
Design costs
125,000
Distribution costs Customer-service costs
The life-cycle costs for the ‘Easy-accounting’ package are as follows: Life-cycle costs
$
Research & Development costs
280,000
Design costs
125,000
Production costs
402,000
Marketing costs
545,000
Distribution costs Customer-service costs Total Life-cycle costs
45,500 125,000 1,522,500
It clearly takes into consideration the costs of the package incurred during the entire life-cycle. Accordingly, from life-cycle costing, the management can know whether the revenue earned by the product is sufficient to cover the whole costs incurred during its life-cycle. When viewed as a whole, there are opportunities for cost reduction and minimisation (and thereby scope for profit maximisation) whereas these are unlikely to be found when management focuses on maximising profit on a period–by-period basis. In this Study Guide, we will find out about the costs involved at different stages of the life-cycle and the implications of life-cycle costing on pricing, performance management and decision-making.
1. Identify the costs involved at different stages of the life-cycle [Learning outcome a] The term ‘life-cycle costing’ encompasses both the concepts of ‘product life-cycle cost’ and ‘customer lifecycle cost’. 1.1 Conceptualising ‘product life-cycle’ 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. It is launched; it grows and may, at some point of time, die. The progression of a product through these stages is however, not certain. Some products seem to stay in one stage forever (e.g. milk).
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Life-Cycle Costing: A3.3
A product life-cycle may be classified into three broad stages. Each of the stages include at least one of the business functions namely, Research and Development, Design, Production, Marketing, Distribution and Customer service. The stages of a life-cycle are: 1. The planning and design stage. This stage includes the following business functions: a) Research and Development b) Design 2. The manufacturing and sales stage. This stage includes the following business functions: a) Production b) Marketing c) Distribution 3. The service and abandonment stage. This stage includes the following business functions: a) After sales service b) Disposal of production facility Diagram 1: Identify the business functions involved at different stages of a product life-cycle
1.2 Costs committed and costs incurred 1.
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 are termed committed costs.
Studies show that about 80% of the life-cycle costs of a product are committed at its planning and design stage. It is difficult to significantly alter costs after they have been committed. Example The planning and design stage of a product determines its material and labour inputs and the production process. At this stage, costs become committed and broadly determine the future costs that will be incurred during the manufacturing stage. 2.
Costs are incurred when a resource is used or sacrificed. The actual cost of a product is built up mostly in the manufacturing stage and in the service and abandonment stage. Costs incurred vis-à-vis the costs committed at different stages of the product life-cycle are compared in the following diagram:
A3.4: Specific Cost And Management Accounting Techniques
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Diagram 2: Comparison of costs committed and cost incurred in product life-cycle stages
Stages of product life-cycle 1.3 Costs involved at different stages of product life-cycle For each of the business functions at each stage of life-cycle of each product, costs keep on being incurred. Let us try to identify the possible costs at each stage of the life-cycle: 1.
At the planning and design stage: Research and Development cost, Costs of product design, etc.
2.
At the manufacturing stage: This stage witnesses both growth and maturity in sales. All the manufacturing, marketing, selling and distribution costs are incurred at this stage.
3.
At the service and abandonment stage: This last stage of the product life-cycle is signified by a decline in sales volume. The demand for the product declines at this stage. The producers may be required to provide after sales service for the already sold products. Costs that are incurred in this stage include all costs relating to after sales service including provision of spares and expert services and costs of abandonment and disposal of the product.
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. Diagram 3: Time frame of a typical Product Life-Cycle Cost
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Life-Cycle Costing: A3.5
1.4 Conceptualising customer life-cycle costing A different notion of life-cycle costs is customer life-cycle costs. Customer life-cycle costs include the total costs incurred by a customer to acquire and use a product or service until it is replaced. Customer life-cycle costs for a car, for example, include the cost of car itself plus the costs of operating and maintaining the car less the disposal price of the car. Customer life-cycle costs can be an important consideration in the pricing decision. The best way to understand customer life-cycle costing is to look at an example. Example Suppose you are shopping for a new water heater. One costs $50 more than the other, but is better insulated and has a lower operating cost. Let’s assume they can both last ten years. It is observed that if one costs $25 more per year to operate, that difference amounts to $250 over the ten years. If we discount those savings back to today and also consider the current inflation rate, it is worth about $200 today. Since that is much more than the purchase cost difference, an initial investment of $50 is worth it from your point of view as a consumer. On the other hand, the manufacturer of the better insulated variety of water heater may think of increasing its product price considering its much advantageous customer life-cycle cost. SYNOPSIS Costs involved at different stages of life-cycle
2. Explain the implications of life-cycle costing on pricing, performance management and decision-making [Learning outcome b] 2.1 Implications of life-cycle costing on pricing Most accounting systems report revenue, costs and profit on a periodic basis, and product profits are not monitored over their life-cycle. A failure to trace all costs of products over their life-cycle hinders management’s understanding of product profitability, because a product’s actual life-cycle profit is unknown. Life-cycle costing estimates and accumulates costs over a product’s entire life-cycle so as to determine whether the profits earned during the manufacturing phase will cover the costs incurred during the pre- and postmanufacturing stages. To estimate the life-cycle costs it is essential to identify the costs incurred through different stages of life-cycle of a product. Only on knowing the life-cycle costs of a product, can one appropriately decide on its price. Moreover, if viewed from the angle of customer life-cycle costs, the life-cycle costs provide input for pricing across the lifecycle. Example An automobile manufacturer’s aim is to design cars that would minimise maintenance cost. The company expects to charge a higher price and / or gain greater market share by selling these cars. Similarly, manufacturers of washing machines and dishwashers charge higher prices for models that save electricity and have low maintenance costs. 2.2 Implications of life-cycle costing on performance management Life-cycle costing helps management to understand the cost consequences of developing and making a product and to identify areas in which cost reduction efforts are likely to be most effective.
A3.6: Specific Cost And Management Accounting Techniques
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Since life-cycle analysis highlights the committed costs of a product, it is possible, through emphasis on product planning, product design and development, to reduce product cost during its life-cycle. Life-cycle costing forms an input to evaluation processes such as value management, economic appraisal and financial appraisal. The old proverb, ‘time is money’, still holds true. The management of time is immensely important if the profit of a product is to be maximised. The management of time is particularly emphasised in life-cycle costing. Since a reduction in time during the development stage causes a decrease in cost or an increase in revenue, it in turn causes an increase in profit. 2.3 Implications of life-cycle costing on decision-making The importance of life-cycle costing lies in the consideration of the whole life-cycle. Life-cycle costing provides a long-term picture of product profitability, feedback on the effectiveness of initial planning and cost data to clarify the economic impact of alternatives chosen in the design, engineering phase etc. It is also considered a way to enhance the control of manufacturing costs. When viewed as a whole, cost reduction and minimisation opportunities as well as revenue extension opportunities will present themselves. It provides premises for decision-making regarding product introduction, product mix and regarding discontinuation of the products. SYNOPSIS
Quick Quiz 1.
What is meant by the term ‘product life-cycle costing’?
2.
What is meant by the term ‘customer life-cycle costing’?
3.
State the concept of the ‘committed cost’
4.
Briefly state the stages of a ‘product life-cycle’
5.
Briefly describe the implications of life-cycle costing on performance management
Answer to Quick Quiz 1.
Product life-cycle costing estimates and accumulates costs over a product’s entire life-cycle (sometimes a span of several calendar periods). It helps to identify whether the profits earned during the manufacturing stage will cover the costs incurred during the pre- and post-manufacturing stages.
2.
Customer life-cycle costing involves calculating the total costs incurred by a customer to acquire and use a product or service until it is replaced. Customer life-cycle costs for a car, for example, include the cost of car itself plus the costs of operating and maintaining the car minus the disposal price of the car.
3.
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 are termed committed costs (e.g. depreciation of any non-current asset)
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Life-Cycle Costing: A3.7
A product life-cycle may be classified into three broad stages. Each of the stages includes at least one of the business functions namely, Research and Development, Design, Production, Marketing, Distribution and Customer service. The stages of a life-cycle are: (a) The planning and design stage. This stage includes the following business functions: i. ii.
Research and Development Design
(b) The manufacturing and sales stage. This stage includes the following business functions: i. Production ii. Marketing iii. Distribution (c) The service and abandonment stage. This stage includes the following business functions: i. ii.
After sales service Disposal of production facility
5. Life-cycle costing helps management to understand the cost consequences of developing and making a product and to identify areas in which cost reduction efforts are likely to be most effective. Since life-cycle analysis indicates the committed costs of a product, it is possible, through emphasis on product planning, product design and development, to reduce product cost during its life-cycle. Life-cycle costing forms an input to evaluation processes such as value management, economic appraisal and financial appraisal.
Self Examination Questions Question 1 Futuristic Software Inc, a computer software company is developing a new accounting package, “Future Accounting”. The following are the budgeted amounts for Future Accounting Package over a six-year product life-cycle. Year 1 and 2 Research and Development costs Design costs
Year 3 to 6
Production costs Marketing costs Distribution costs Customer-service costs
$ 360,000 240,000
One-Time Setup Costs $ 150,000 105,000 75,000 120,000
Variable Cost per package $ 37.50 36 24 45
To be profitable, Futuristic Software Inc must generate revenues to recover costs of all six-business functions taken together and, in particular, its high non-production costs. Futuristic Software Inc wants to decide between three alternative selling prices i.e., $350, $430 and $550, so as to maximise life-cycle operating income. Sales volumes at these prices have been estimated at 7,500 units, 6,000 units and 3,750 units respectively. Identify which option maximises life-cycle operating income.
A3.8: Specific Cost And Management Accounting Techniques
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Question 2 Ace-soft Technologies Plc is examining the profitability and pricing policies of three of its recently developed software packages:
Electrical Genius: package for electrical engineers Mechanical Genius: package for mechanical engineers Industrial Genius: package for industrial engineers
Summary details on each package over their two-year “cradle-to-grave” product lives are as follows: Number of units sold Package
Selling Price $
Electrical Genius Mechanical Genius Industrial Genius
Year 1
Year 2
235
2,.150
8,100
285
2,200
3,150
185
5,100
3,700
Assume that no inventory remains on hand at the end of year 2. Ace-soft Technologies is deciding which product lines to emphasise. In the past two years, profitability has been mediocre. Ace-soft Technologies is particularly concerned with the increase in R & D costs. An analyst pointed out that for one of its most recent packages (Industrial Genius), major efforts had been made to reduce R &D costs. The engineering software manager decides to collect the following life-cycle revenue and cost information for the Electrical Genius, Mechanical Genius and Industrial Genius packages: Electrical Genius
Mechanical Genius
Industrial Genius
Year 1 $ 505,250
Year 2 $ 1,903,500
Year 1 $ 627,000
Year 2 $ 897,750
Year 1 $ 943,500
Year 2 $ 684,500
R & D cost
760,000
0
495,000
0
215,000
0
Design of product
215,000
25,000
115,000
7,750
83,500
12,000
55,250
221,000
90,000
90,000
162,000
54,000
155,000
395,000
132,000
153,000
224,000
198,000
Distribution
19,000
66,500
23,000
33,000
58,000
35,000
Customer service
45,000
270,000
33,000
99,000
202,000
322,000
Revenues Costs:
Manufacturing Marketing
Required: (a) How does a product life-cycle income statement differ from a conventional income statement? What are the benefits of using a product life-cycle reporting format? (b) Present a product life-cycle income statement for each software package. Which package is the most profitable, and which is the least profitable? Ignore the time value of money. (c) How do the three software packages differ in their cost structure (the percentage of the totals costs in each cost category)? Question 3 Donald products make digital cameras. Donald is preparing a product life-cycle budget for a new digital camera, DC3. Development on the new digital camera is to start shortly. Estimates for DC3 are as follows:
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Life-Cycle Costing: A3.9 $ 800,000 80
Life-cycle units manufactured and sold Selling price per camera Life-cycle costs: R & D and design costs Manufacturing: Variable cost per camera Variable cost per batch No. of batches Fixed costs Marketing: Variable cost per camera Fixed costs Distribution: Variable cost per batch No. of batches Fixed costs Customer-service costs per camera
2,000,000 30 1,200 1,000 3,600,000 6.40 2,000,000 560 320 1,440,000 3.00
Ignore the time value of money. Required: (a) Calculate the budgeted life-cycle operating income for the new digital camera. (b) What percentage of the budgeted total product life-cycle costs will be incurred by the end of the R & D and design stages? (c) An analysis reveals that 80% of the budgeted total product life-cycle costs of the new digital camera will be committed at the R & D and design stages. What are the implications for managing DC3’s costs? (d) Donald’s Market Research Department estimates that reducing DC3’s price by $6 will increase life-cycle unit sales by 10%. If unit sales increase by 10%, design plans to increase manufacturing and distribution batch sizes by 10% as well. Assume that all variable costs per camera, variable cost per batch, and fixed costs will remain the same. Should Donald reduce DC3’s price by $6? Show your calculations.
Answers to Self Examination Questions Answer 1 Statement showing comparison of alternative life-cycle revenue, life-cycle costs and life-cycle operating income
Selling price per package Sales quantity in units
Alternative Selling Price/ Sales-Quantity Combination A B C $350 $430 $550 7,500 6,000 3,750
A. Life-cycle revenues B. Life-cycle costs : R & D costs Design cost of product/ process Production costs (w1) Marketing costs (w2) Distribution costs (w3) Customer-service costs (w4)
$2,625,000
$2,580,000
$2,062,500
$360,000 $240,000 $431,250 $375,000 $255,000 $457,500
$360,000 $240,000 $375,000 $321,000 $219,000 $390,000
$360,000 $240,000 $290,625 $240,000 $165,000 $288,750
Total life-cycle costs C. Life-cycle operating income (A - B)
$2,118,750 $506,250
$1,905,000 $675,000
$1,584,375 $478,125
A3.10: Specific Cost And Management Accounting Techniques
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Clearly, alternative B with a selling price per package of $430 and a sales volume of 6,000 units yields the highest operating income. Workings 1. Production costsFor A, $150,000 + (7,500 units x $37.50/package) = $431,250 For B, $150,000 + (6,000 units x $37.50/package) = $375,000 For C, $150,000 + (3,750 units x $37.50/package) = $290,625 2. Marketing CostsFor A, $105,000 + (7,500 units x $36/package) = $375,000 For B, $105,000 + (6,000 units x $36/package) = $321,000 For C, $105,000 + (3,750 units x $36/package) = $240,000 3. Distribution costsFor A, $75,000 + (7,500 units x $24/package) = $255,000 For B, $75,000 + (6,000 units x $24/package) = $219,000 For C, $75,000 + (3,750 units x $24/package) = $165,000 4. Customer-service costsFor A, $120,000 + (7,500 units x $45/package) = $457,500 For B, $120,000 + (6,000 units x $45/package) = $390,000 For C, $120,000 + (3,750 units x $45/package) = $288,750 Note Life-cycle costs provide useful information for strategically evaluating pricing decisions. While calculating life-cycle revenue and life-cycle costs, it may be noted that calculation of annual revenue or annual cost is meaningless. Here, the revenue and the costs for the entire life-cycle of the product will have to be considered. Again, in annual accounts, the non-production costs such as Research and development cost and Design cost are normally considered as deferred cost and are amortized during the useful life of the product. But, so as to know the life-cycle revenue and costs of the product, one needs to consider revenue and costs for the whole life-cycle. Answer 2 (a) Difference between a product life-cycle income statement and a conventional income statement A product life-cycle income statement considers all revenue earned and all costs incurred during the lifecycle of a product. The life-cycle of the product may span a number of years. On the other hand, in a conventional accounting system, income statements are prepared periodically, i.e. product costs and revenues are reported period-wise. This prevents consideration of the total profitability of an individual product or any other cost object and does not allow the full picture to be seen. Moreover, the life-cycle costs will include the research and development cost and the design cost. In contrast, in a conventional accounting system, the non-production costs such as research and development cost and design cost are normally considered to be deferred costs and are amortized during the useful life of the product. The benefits of using a product life-cycle reporting format: Life-cycle costing provides a long-term picture of product profitability, feedback on effectiveness of initial planning and cost data to clarify the economic impact of alternatives chosen in the design, engineering phase etc. It is also considered a way to enhance the control of manufacturing costs. When viewed as a whole, cost reduction and minimisation opportunities as well as revenue extension opportunities will present themselves. It provides premises for decision-making regarding product introduction, product mix and regarding discontinuation of the products.
© GTG
Life-Cycle Costing: A3.11
(b) Alhough not desired in the problem, a conventional income statement has been prepared so as to show the difference between the conventional income statement and the product life-cycle income statement Step 1 Prepare the conventional income statement Conventional Income Statement
Revenues Costs: R & D cost Design of product Manufacturing Marketing Distribution Customer service Total cost Net operating income
Electrical Genius Year 1 Year 2 $ $ 505,250 1,903,500
Mechanical Genius Year 1 Year 2 $ $ 627,000 897,750
Industrial Genius Year 1 Year 2 $ $ 943,500 684,500
760,000 215,000
0 25,000
495,000 115,000
0 7,750
215,000 83,500
0 12,000
55,250 155,000 19,000
221,000 395,000 66,500
90,000 132,000 23,000
90,000 153,000 33,000
162,000 224,000 58,000
54,000 198,000 35,000
45,000 1,249,250
270,000 977,500
33,000 888,000
99,000 382,750
202,000 944,500
322,000 621,000
(744,000)
926,000
(261,000)
515,000
(1,000)
63,500
Step 2 Prepare the product life-cycle income statement Product Life-Cycle Income Statement
Electrical Genius
Mechanical Genius
Industrial Genius
$ 2,408,750
$ 1,524,750
$ 1,628,000
R & D cost
760,000
495,000
215,000
Design of product
240,000
122,750
95,500
Manufacturing
276,250
180,000
216,000
Marketing
550,000
285,000
422,000
85,500
56,000
93,000
315,000
132,000
524,000
2,226,750
1,270,750
1,565,500
182,000
254,000
$62,500
Revenues Costs:
Distribution Customer service Total cost Net operating income (for the life-cycle)
From the life-cycle net operating income, it is apparent that ‘Mechanical genius’ is the most profitable package. On the other hand, ‘Industrial Genius’ is the least profitable package.
A3.12: Specific Cost And Management Accounting Techniques
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Workings Electrical Genius Year 1 Year 2 $ $ A. Revenues B. Costs: R & D cost Design of product Manufacturing Marketing Distribution Customer service Total cost C. Net operating income (A – B)
Total $
505,250
$1,903,500
$2,408,750
760,000 215,000 55,250 155,000 19,000 45,000
0 25,000 221,000 395,000 66,500 270,000
760,000 240,000 276250 550,000 85,500 315,000
1,249,250
977,500
2,226,750
(744,000)
926,000
182,000
Mechanical Genius Year 1 Year 2 $ $
Total $
A. Revenues B. Costs: R & D cost Design of product Manufacturing Marketing Distribution Customer service
627,000
897,750
1,524,750
495,000 115,000 90,000 132,000 23,000 33,000
0 7,750 90,000 153,000 33,000 99,000
495,000 122,750 180,000 285,000 56,000 132,000
Total cost
888,000
382,750
1,270,750
(261,000)
515,000
254,000
C. Net operating income (A – B)
Industrial Genius Year 1 Year 2 $ $ A. Revenues B. Costs: R & D cost Design of product Manufacturing Marketing Distribution Customer service Total cost C. Net operating income (A – B)
Total $
943,500
684,500
1,628,000
215,000 83,500 162,000 224,000 58,000 202,000
0 12,000 54,000 198,000 35,000 322,000
215,000 95,500 216,000 422,000 93,000 524,000
944,500
621,000
1,565,500
(1,000)
63,500
62,500
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Life-Cycle Costing: A3.13
(c) The cost structures of different software packages are displayed below in percentage terms Electrical Genius Costs ($)
%
Mechanical Genius Costs ($) %
Industrial Genius Costs ($) %
Planning and design costs R & D cost Design of product
760,000 240,000
34.13 10.78
495,000 122,750
38.95 9.66
215,000 95,500
13.73 6.10
Manufacturing and sales cost Manufacturing Marketing Distribution
276,250 550,000 85,500
12.41 24.70 3.84
180,000 285,000 56,000
14.16 22.43 4.41
216,000 422,000 93,000
13.80 26.96 5.94
Service and abandonment cost Customer service Total
315,000 2,226,750
14.15 100
132,000 1,270,750
10.39 100
524,000 1565,500
33.47 100
Answer 3 (a) Product Life-cycle Income Statement Particulars
$
Life-cycle units manufactured and sold Selling price per camera A. Life-cycle revenue B. Life-cycle costs: R & D and design costs Manufacturing (w1) Marketing (w2) Distribution (w3) Customer-service costs (w4) Total Life-cycle costs
800,000 80 64,000,000
C. Life-cycle operating income (A - B)
22,060,800
Workings 1. Total Manufacturing Cost: Fixed cost Variable cost of camera (800,000 cameras x $30/camera) Variable cost of batch (1000 batches x $1,200/batch) Total
= $3,600,000 = $24,000,000 = $1,200,000 = $28,800,000
2. Total Marketing Cost: Fixed cost = $2,000,000 Variable cost of camera = $5,120,000 (800,000 cameras x $6.40/camera) Total = $7,120,000
2,000,000 28,800,000 7,120,000 1,619,200 2,400,000 41,939,200
A3.14: Specific Cost And Management Accounting Techniques
3. Total Distribution Cost: Fixed cost Variable cost of batch (320 batches x $560/batch)
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= $1,440,000 = $179,200 Total
= $1,619,200
4. Total Customer-service Cost: (800,000 cameras x $3.00/camera)
= $2,400,000
(b) The percentage of the budgeted total product life-cycle costs that will be incurred by the end of the R & D and design stage is = (R & D and design cost/Total product life-cycle costs) x 100 = (2,000,000/41,939,200) x 100 = 4.77%. Note Although the costs committed at the Research and Development and design stage are normally 80% (approximately) of the budgeted total product cost, the actual costs incurred are only 4.77%. (c) It had been revealed that the committed costs at the R & D and design stage for the product DC3 were 80% of the total budgeted costs. This implies that the R & D and design stage itself determines what the manufacturing cost of the product will be. If an appropriate product design is made by employing the techniques of value engineering, the actual costs in the subsequent stages of the product life-cycle can be greatly reduced. To manage DC3’s costs, it is necessary in the design stage to identify the product features which are non-value added and accordingly to curtail these features. (d) If the price of DC3 is reduced by £6, The proposed selling of the product will be $ (80 – 6) = $74 Accordingly, the quantity sold will increase by 10%, i.e., number of units to be sold during the life-cycle will be 800,000 x 110% = 880,000 units. Batch size would also increase to $1,100.
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