3 Life-cycle costing
3.1 Definition of life-cycle costing
Many goods now have very short life-cycle, e.g. personal computers. In addition many products have very high costs which are incurred before the good is launched, e.g. development of new cars.
Traditional costing techniques based around annual periods may give a misleading impression of the costs and profitability of a good.
The commitment of a high proportion of a product’s life-cycle costs at the very early stages of the cycle has led to the need for accounting systems that compare the revenues from a product with all the costs incurred over the entire product life cycle.
Life-cycle costing:
§ is the profiling of cost over a product’s life, including the preproduction stage
§ tracks and accumulates the actual costs and revenues attributable to each product from inception to abandonment
§ enables a product’s true profitability to be determined at the end of its economic life.
3.2 The costs involved at different stages in the product life-cycle
Most products have a distinct product life-cycle:
Specific costs may be associated with each stage.
1 Development and launch stage
- A high level of setup costs will already have been incurred by this stage (preproduction costs), including research and development (R&D), product design and building of production facilities.
- Success depends upon awareness and trial of the product by consumers, so this stage is likely to be accompanied by extensive marketing and promotion costs.
2 Growth stage
- Marketing and promotion will continue through this stage.
- In this stage sales volume increases dramatically, and unit costs fall as fixed costs are recovered over greater volumes.
3 Maturity stage
- Initially profits will continue to increase, as initial setup and fixed costs are recovered.
- Marketing and distribution economies are achieved.
- However, price competition and product differentiation will start to erode profitability as firms compete for the limited new customers remaining.
4 Decline stage
- Eventually, the product will move towards obsolescence as it is replaced by new and better alternatives.
- The product will be abandoned when profits fall to an unacceptable level, or when further capital commitment is required.
- Meanwhile, a replacement product will need to have been developed, incurring new levels of R&D and other product setup costs.
- Alternatively additional development costs may be incurred to refine the model to extend the life-cycle (this is typical with cars where ‘product evolution’ is the norm rather than ‘product revolution’).
3.3 The implications of life-cycle costing
Pricing
§ Pricing decisions can be based on total life-cycle costs rather than simply the costs for the current period.
Illustration 6 – Targeting costs
A major bank and provider of credit cards wished to reduce the time taken to process credit card application forms and issue a credit card. The staff responsible for processing applications and issuing new cards were asked suggest how the period (of 14 days) could be reduced.
The staff were unable to identify any significant time savings. The senior executive responsible for the area decided to pursue a version of target costing and instructed his staff that new cards were to be issued within 24 hours of an application being received and it was their responsibility to identify how this could be achieved.
The imposition of this target forced a new approach to the problem and radical new ways of processing and approving applications were identified and implemented with the result that the 24-hour target was met.
Decision making
§ In deciding to produce or purchase a product or service, a timetable of life-cycle costs helps show what costs need to be allocated to a product so that an organization can recover its costs.
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