Lifecycle costing

Lifecycle Costing

Rather than simply looking at a product's costs for one period, lifecycle costing seeks to understand costs over the whole lifecycle.

Product lifecycles

Most products have a distinct product life-cycle:

Specific costs may be associated with each stage.

(1) Pre-production/Product development stage

  • A high level of setup costs will be incurred in this stage (preproduction costs), including research and development (R&D), product design and building of production facilities.

(2) Launch/Market development stage

  • 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.

(3) 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.

(4) 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

(5) Decline stage

  • Marketing costs are usually cut as the product is phased out
  • Production economies may be lost as volumes fall
  • 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').

Managing Lifecycle Costs

A product's costs are not evenly spread through its life.

According to Berliner and Brimson (1988), companies operating in an advanced manufacturing environment are finding that about 90% of a product's lifecycle costs are determined by decisions made early in the cycle. In many industries, a large fraction of the life-cycle costs consists of costs incurred on product design, prototyping, programming, process design and equipment acquisition.

This had created a need to ensure that the tightest controls are at the design stage, i.e. before a launch, because most costs are committed, or 'locked-in', at this point in time.

Management Accounting systems should therefore be developed that aid the planning and control of product lifecycle costs and monitor spending and commitments at the early stages of a product's life cycle.

Maximising a product's lifecycle return

There are a number of factors that need to be managed in order to maximise a product's return over its lifecycle:

Design costs out of the product

It was stated earlier that around 90% of a product's costs were often incurred at the design and development stages of its life. Decisions made then commit the organisation to incurring the costs at a later date, because the design of the product determines the number of components, the production method, etc. It is absolutely vital therefore that design teams do not work in isolation but as part of a cross-functional team in order to minimise costs over the whole lifecycle.

Value engineering helps here; for example, Russian liquid-fuel rocket motors are intentionally designed to allow leak-free welding.This reduces costs by eliminating grinding and finishing operations (these operations would not help the motor to function better anyway.)

Minimise the time to market

In a world where competitors watch each other keenly to see what new products will be launched, it is vital to get any new product into the marketplace as quickly as possible. The competitors will monitor each other closely so that they can launch rival products as soon as possible in order to maintain profitability. It is vital, therefore, for the first organisation to launch its product as quickly as possible after the concept has been developed, so that it has as long as possible to establish the product in the market and to make a profit before competition increases. Often it is not so much costs that reduce profits as time wasted.

Maximise the length of the life cycle itself

Generally, the longer the life cycle, the greater the profit that will be generated, assuming that production ceases once the product goes into decline and becomes unprofitable. One way to maximise the lifecycle is to get the product to market as quickly as possible because this should maximise the time in which the product generates a profit.

Another way of extending a product's life is to find other uses, or markets, for the product. Other product uses may not be obvious when the product is still in its planning stage and need to be planned and managed later on. On the other hand, it may be possible to plan for a staggered entry into different markets at the planning stage.

Many organisations stagger the launch of their products in different world markets in order to reduce costs, increase revenue and prolong the overall life of the product. A current example is the way in which new films are released in the USA months before the UK launch.This is done to build up the enthusiasm for the film and to increase revenues overall. Other companies may not have the funds to launch worldwide at the same moment and may be forced to stagger it. Skimming the market is another way to prolong life and to maximise the revenue over the product's life.

Customer lifecycle costing

Not all investment decisions involve large initial capital outflows or the purchase of physical assets. The decision to serve and retain customers can also be a capital budgeting decision even though the initial outlay may be small.

For example a credit card company or an insurance company will have to choose which customers they take on and then register them on the company's records. The company incurs initial costs due to the paperwork, checking creditworthiness, opening policies,etc. for new customers. It takes some time before these initial costs are recouped. Research has also shown that the longer a customer stays with the company the more profitable that customer becomes to the company.

Thus it becomes important to retain customers, whether by good service, discounts, other benefits, etc.

A customer's 'life' can be discounted and decisions made as to the value of, say, a 'five-year-old' customer. Eventually a point arises where profit no longer continues to grow; this plateau is reached between about five years and 20 years depending on the nature of the business. Therefore by studying the increased revenue and decreased costs generated by an 'old' customer, management can find strategies to meet their needs better and to retain them.

Many manufacturing companies only supply a small number of customers, say between six and ten, and so they can cost customers relatively easily. Other companies such as banks and supermarkets have many customers and cannot easily analyse every single customer. In this case similar customers are grouped together to form category types and these can then be analysed in terms of profitability.

For example, the UK banks analyse customers in terms of fruits:

  • At the top of the tree are plums - which are classified as 'college educated married men aged 44-65 living in the south of England with high income  and high savings'. 

  • Other customers are classified as pears, apples, oranges, dates, grapes and lemons.

  • Customers tend to move from one category to another as they age and as their financial habits change. Customers with large mortgages, for example, are more valuable to the bank than customers who do not have a large income and do not borrow money. Banks are not keen on keeping the latter type of customer.

Created at 8/7/2012 10:43 AM  by System Account  (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London
Last modified at 11/14/2012 12:48 PM  by System Account  (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London

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