Life Cycle Cost and Profit Calculations, and the Benefits of Life Cycle Costing

The previous topic showed what belongs in the life cycle cost of a product or an asset. This topic puts numbers on it.

A company that plans a new product must know the cost over the whole life, per unit sold, so that it can test whether the price it hopes for will recover everything: the research that came first, the marketing that follows, the production in every year and the cost of withdrawal.

A company that must choose a machine must compare options whose costs arise in different years, so the timing matters too. This topic explains how to calculate life cycle cost per unit and life cycle profit, how to discount the costs of an asset over its life, and what benefits life cycle costing brings to pricing, performance management and decisions.

It builds on the life cycle costing stages topic. The next topic covers throughput accounting.

Calculating life cycle cost and profit

Life cycle costing in manufacturing evaluates all the costs of a product or process from inception to disposal. It tracks and accumulates the actual (or estimated) costs and revenue attributable to a product from its start to its abandonment after its economic life. The economic analysis assesses the total cost of acquisition, ownership and disposal over a period.

The cost schedule for a new product

• Initial costs. Research and development, and product design, incurred before sales begin.
• Marketing costs. Often in every year of the life, higher at launch.
• Manufacturing costs. Variable costs per unit × units in each year, plus fixed production costs in each year.
• Selling and distribution costs. Variable costs per unit × units, plus fixed costs.
• End-of-life costs where relevant, such as withdrawal and warranty support.

Add them all, over every year, for the total life cycle cost. Divide by the total units sold in all years for the cost per unit. Compare that with the selling price: over the entire life the price must be high enough to earn a profit after all costs, including start-up and end-of-life costs as well as annual operating costs.

Discounted life cycle cost

When the costs of an asset arise over many years, they are discounted to present value at the cost of capital, and the option with the lowest present value of life cycle cost is preferred, other things being equal. The purchase cost is at time 0. Running costs of the same amount each year are multiplied by the annuity factor.

One-off costs such as an overhaul in a given year, or a disposal cost at the end, are multiplied by the discount factor for that year. A scrap value received is deducted.

The benefits of life cycle costing

• Early view of profitability. The potential profit of a product can be assessed before major development costs are incurred, and unprofitable products can be dropped early before costs are committed.
• Cost reduction. Techniques can be used to reduce costs over the whole life.
• Pricing. The pricing strategy can be set before the product enters production, which may mean better control of marketing and distribution costs.
• Speed to market. Attention is focused on shortening research and development, because the longer a company operates without competitors, the more revenue it earns and the sooner it breaks even.
• Learning. Actual performance can be monitored against plans, so lessons are learned and estimating techniques improve.

Help with pricing, performance management and decisions

• Pricing. As a product moves from one stage to the next, pricing may need to change to hold market share, for example lower prices as it reaches maturity and volume stops rising. Over the whole life, prices must be high enough to recover all costs.
• Performance management. Financial performance changes with the stage, so an improvement or decline may be linked to the life cycle and should to some extent be expected, not blamed on managers.
• Decision-making. It helps in decisions to invest more in a product or to withdraw it.

Limitations

Estimates of sales, price and costs over several years are uncertain, so the answer is only as good as the forecasts: use sensitivity analysis. Costs that have already been spent (sunk) must not drive a decision about the future. Allocating overhead to a product over its life needs a fair method. And a product-by-product view may miss links between products.

Layouts

1. Variable cost for a year = cost per unit × units in that year. Add fixed costs for the year.
2. Life cycle cost = Σ all costs, all years. Cost per unit = life cycle cost ÷ total units.
3. Life cycle profit = total revenue − life cycle cost. Profit per unit = price − cost per unit. Margin = profit ÷ revenue.
4. Present value of life cycle cost = initial cost + running cost × annuity factor + one-off costs × discount factor − scrap value × discount factor.
5. Break-even price = life cycle cost per unit.

Money is in naira, per-unit figures to two decimal places, and each answer is rounded once at the end. Factors are to four decimal places.

Worked examples

1. Initial costs.
   120,000 + 380,000 = ₦500,000.
2. Marketing.
   300,000 + 700,000 + 800,000 = ₦1,800,000.
3. Variable manufacturing.
   25,000 × 40 = 1,000,000
   35,000 × 45 = 1,575,000.
   Total ₦2,575,000.
4. Fixed production.
   400,000 + 850,000 = ₦1,250,000.
5. Variable selling.
   25,000 × 4 = 100,000
   35,000 × 5 = 175,000.
   Total ₦275,000.
6. Fixed selling.
   180,000 + 210,000 = ₦390,000.
7. Life cycle cost.
   500,000 + 1,800,000 + 2,575,000 + 1,250,000 + 275,000 + 390,000 = ₦6,790,000.
8. Cost per unit.
   6,790,000 ÷ 60,000 units = ₦113.17.
9. Revenue and profit.
   60,000 × 140 = ₦8,400,000.
   Profit 8,400,000 − 6,790,000 = ₦1,610,000; per unit ₦26.83; margin 19.2%.
10. Comment. The price of ₦140 must be at least ₦113.17 to break even over the life. The company should test what happens if sales fall short, because the fixed and marketing costs do not fall with volume.

1. Purchase. ₦9.0000m.
2. Running costs.
   1.6 × 3.6048 = ₦5.7677m.
3. Overhaul.
   2.0 × 0.7118 = ₦1.4236m.
4. Disposal cost.
   0.8 × 0.5674 = ₦0.4539m.
5. Present value of life cycle cost.
   9.0000 + 5.7677 + 1.4236 + 0.4539 = ₦16.65m.
6. Comment. The running costs are the largest part of the total after the purchase price, so a cheaper machine that costs more to run could be the worse choice. Compare with the alternative on the same basis.

Expect variants: a scrap value, running costs that rise each year, a period in which sales are zero, or a question that gives the cost per unit and asks for the minimum price.

Common mistakes

• Dividing by units in one year. Divide by all units over the whole life.
• Leaving out the development year or marketing. Every cost in every year counts.
• Forgetting fixed costs in each year.
• Not discounting when costs arise over many years and a rate is given.
• Adding scrap value instead of deducting it.
• Quoting benefits without applying them. Link each to the business in the question.

Quick revision

• Life cycle cost per unit = total of all costs in all years ÷ total units over the life.
• Life cycle profit = revenue − life cycle cost. Price must recover all costs over the life.
• Assets: present value of life cycle cost; purchase, running (annuity), one-off costs (discount factors), less scrap.
• Benefits: early profitability view, cost reduction, pricing, speed to market, learning, decisions.

How the marks are earned

• Calculate: a mark for each cost line, the total, the per-unit figure and the profit.
• Explain benefits: one mark per developed benefit, with an example.
• Advise: a conclusion on price or choice of asset.

Practice questions

These are original questions, written in the style of the Skills examination. Work each one before you open the answer.

Recall check: multiple choice

Section B style: written questions

Model answers

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