Life Cycle Costing

It is a modern approach for planning of Capital Assets with the objective of minimization of cost and maximization of profit. It is a method which is used to set the cost of a product. In this method of costing we look at the accumulated cost over the entire product lifecycle, which includes cost right from the start from R&D to removal of the product from the market. So here we don’t include periods of time, splitting up or cost in that period of time, we include cost of the product over its lifecycle right through to the end.

Lifecycle of the product can be split into five different phases:

1) Development2) Introduction3) Growth4) Maturity5) Decline

This life cycle will be different for all products, not all products will have the same lifecycle. Some products may have a short lifecycle; some might have a long one.

The key concept behind Life cycle costing is that we are no longer looking at accounting periods, we don’t talk about periods of month or a year we take into consideration the entire product lifecycle, it may last as long as possible. Hence when we look at the entire life cycle it will enable us to set a better price for our product.

For e.g.: If we look at a product, produced by a manufacturing company with 4 year lifecycle and we are given various costs over the lifecycle of that product. Suppose we have 6 costs as mentioned below and these costs are mentioned at different periods of the lifecycle of the product. So we have to add the total cost over the lifecycle of the product.

So from the example we see that the R&D cost is only included in year 1, while the product is included in all the rest of the three years. The total cost over the 4 years for different phases amounts to 1044.

Phases of Lifecycle:

This shows the 5 stages as mentioned earlier in the document. Half way up th diagram we have the zero point. The red line depicts the sales and the blue line, the profit.

1) R&D Stage: a) The sales at this point are zero because product is not the market yet and the profit is going

down, this is because the money is spent on R&D but there are no sales yet so the product is loss making.

b) Cost Involved: costs for R&D, for testing of the product and some capital investment would also be required to buy new equipment or machinery to do testing or do research and develop the product. It may or may not sometimes include the training costs of employees.

c) This phase can take up large percentage of total costs of the product; it may be as large as 90%. So we would have to try and minimize this to a large extent.

2) Introduction Stage: At this stage we see that the sales begin but we are still making a loss. The point where the profit (blue line) crosses the zero line that is the breakeven point.

3) Growth Phase: Sales continues to increase and we start making profit.

4) Maturity Stage: Still we see growth in both the sales and profit but the percentage increasein profit has declined.

5) Decline: Further the sales continue to decrease and the company starts making loss.

After this stage we choose the take the product back from the market.

Calculation of Lifecycle Costing:

Allocate the total costs of the lifecycle to the units of the product produced. Here is an illustration to explain this.

Here the total costs are allocated to the different phases and then this total cost is allocated to the product and the cost per unit is determined.

Advantages:

1) Over Traditional Costing:

In traditional costing we write off the R&D costs in the period which they are incurred, this means that we write the new R&D costs over the revenue that we generate from the old products. So we are generating the revenue from the old products and writing off the costs from the new products against that revenue and this can make the old products look less profitable.

2) Product is priced up to cover the lifecycle costs.3) It enables companies to track costs through the lifecycle of the product.4) It also enables the business to focus on early decisions.5) It also minimizes the time to reach the product.