Life cycle costing

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Life-Cycle Costing

Life-cycle costing tracks and accumulates the actual costs and revenues attributable to each product from inception to abandonment.

It enables a product’s true profitability to be determined at the end of the economic life.

Traditional cost accounting systems do not accumulate costs over a product’s entire life but focus instead on (normally) twelve month accounting periods.

As a result the total profitability of a product over its entire life becomes difficult to determine.

Product Life Cycle

Every product goes through a life cycle

  1. Development. 

    The product has a research and development stage where costs are incurred but no revenue is generated. 

    During this stage, a high level of setup costs will be incurred, including research and development, product design and building of production facilities.

  2. Introduction. 

    The product is introduced to the market. Potential customers will be unaware of the product or service, and the organisation may have to spend further on advertising to bring the product or service to the attention of the market. Therefore, this stage will involve extensive marketing and promotion costs. High prices may be charged to recoup these high development costs.

  3. Growth. 

    The product gains a bigger market as demand builds up. 

    Sales revenues increase and the product begins to make a profit. 

    Marketing and promotion will continue through this stage.  

    Unit costs tend to fall as fixed costs are recovered over greater volumes. 

    Competition also increases and the company may need to reduce prices to remain competitive.

  4. Maturity. 

    Eventually, the growth in demand for the product will slow down and it will enter a period of relative maturity. 

    It will continue to be profitable. 

    However, price competition and product differentiation will start to erode profitability. 

    The product may be modified or improved, as a means of sustaining its demand.

  5. Decline. 

    At some stage, the market will have bought enough of the product and it will therefore reach 'saturation point'. 

    Demand will start to fall and prices will also fall. 

    Eventually it will become a loss maker and this is the time when the organisation should decide to stop selling the product or service. 

    During this stage, the costs involved would be environmental clean-up, disposal and decommissioning. 

    Meanwhile, a replacement product will need to have been developed, incurring new levels of research and development and other setup costs.

The level of sales and profits earned over a life cycle can be illustrated diagrammatically as follows.

ACCA MA F2 B4ab student material Product life cycle graph
Benefits of life cycle costing

The benefits of product life cycle costing are summarised as follows

  1. All costs (production and non production) will be traced to individual products over their complete life cycles and hence individual product profitability can be more accurately measured.

  2. The product life cycle costing results in earlier actions to generate revenue or to lower costs than otherwise might be considered.

  3. Better decisions should follow from a more accurate and realistic assessment of revenues and costs, at least within a particular life cycle stage.

  4. Product life cycle thinking can promote long-term rewarding in contrast to short-term profitability rewarding.

  5. It 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.  

    Very often, 90% of the product’s life-cycle costs are determined by decisions made in the development stage. 

    Therefore, it is important to focus on these costs before the product enters the market.

  6. Identifying the costs incurred during the different stages of a product’s life cycle provides an insight into understanding and managing the total costs incurred throughout its life cycle. 

    Non production costs will become more visible and the potential for their control is increased.

  7. More accurate feedback on the success or failure of new products will be available.

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