Life Cycle Costing: Product Life Cycle Stages and the Costs of Each

A hospital buys a generator for the lowest price on the quotation. Over the next ten years it pays more for diesel, repairs and spare parts than the generator cost, and at the end it pays to remove the old unit.

A manufacturer launches a product that sells well and then discovers that the price it set in the first year cannot recover the research, the marketing and the cost of withdrawing it. Both mistakes come from looking at one part of cost. Life cycle costing looks at all of it, from the first decision to the last cost of disposal.

This topic explains what life cycle costing is, the three categories of cost over the life of an asset or product, the stages of a product’s life and the costs that belong to each, and why so much cost is fixed early. It builds on the target costing and cost gap topic, because target costing and life cycle costing work together.

The next topic covers life cycle cost and profit calculations and the benefits of the method.

What life cycle costing is

Life cycle costing tries to identify the total cost associated with owning an asset, so that decisions on acquisitions can be made on all the costs. It recognises that a decision at the time of acquisition locks in costs for the future. The principle applies to complex and simple purchases alike.

A person who buys a printer is committed to buying the compatible toner cartridges, so choosing between two printers on price alone can be a mistake if the cheaper printer has dearer cartridges. A company that buys a complex asset will also care about reliability, servicing time and maintenance costs.

LCC can be applied to major asset acquisitions and to the introduction of new products to the market.

Three categories of cost

• Acquisition, set-up or market entry costs. Costs incurred at the start to bring the product into production and start selling it, or to complete the construction of a building or other major asset. They are usually one-off capital items and other once-only costs, such as training staff and setting up documentation and performance reporting.
• Operational or running costs. Regular and recurring costs throughout the life of the product or asset. They may change over time: maintenance of equipment, such as lifts in a building, tends to rise as the asset ages.
• End-of-life costs. One-off costs to withdraw the product from the market or demolish or dispose of the asset at the end of its life.

Although costs arise throughout the life, a large proportion is committed very early, when the decision to develop the product or build the asset is made. This is why choices made at the design and purchase stage matter most.

Buildings and other constructed assets

Several designs may be considered for a building, each with a different initial capital cost and different annual running costs. An energy-efficient design lowers energy costs every year. The choice of materials affects the life of the building and the cost of repairs. The design can affect demolition costs.

The preferred design may be the one with the lowest total cost over the building’s life, or the one that gives the best value for money (benefits less costs) over that life. A proper decision needs all costs identified and estimated, and discounted, because ₦1 now is worth more than ₦1 in the future.

The stages of a product life cycle and their costs

Most products made in large quantities and sold to customers pass through six stages: development, introduction, growth, maturity, decline and withdrawal. At each stage the selling price, the costs, the capital invested and the spending on advertising and marketing may differ.

LCC is important in new product launches because the company wants to make a profit on the whole life, so it must recover all the costs: research and development, training, machinery, production, distribution and selling, marketing, working capital, and retirement and disposal.

• Product development. Research and development costs and capital expenditure decisions. Decisions here affect all later costs.
• Introduction to the market. Operating costs begin. Marketing and advertising to raise awareness, with a strong focus on market share, and set-up and expansion of distribution channels.
• Growth. Costs of increasing capacity, perhaps a learning effect and economies of scale, and higher working capital as sales rise.
• Maturity. Costs to maintain manufacturing capacity, and marketing and product enhancement costs to extend maturity.
• Decline. Close attention to cost, because the decision to withdraw may be expensive.
• Withdrawal. Decommissioning costs for assets, possible restructuring costs, and warranties that must still be supported.

Using the stages

A product’s sales revenue and profit follow a typical pattern: little or negative profit in development and introduction, rising profit in growth, the highest profit in maturity, and falling profit in decline. Knowing the pattern helps management to set prices for each stage, to interpret changes in performance (a fall in profit in decline is expected), and to decide on new investment or withdrawal.

The next topic shows how to calculate life cycle cost and profit.

Layouts for life cycle cost

1. Capital cost of an asset = initial cost − scrap or residual value.
2. Number of services = life in miles (or hours) ÷ service interval. Service cost = number of services × cost per service.
3. Running cost = life × running cost per mile (or hour).
4. Life cycle cost = capital cost + service cost + running cost (+ end-of-life cost). Cost per mile or hour = life cycle cost ÷ life.
5. Share of cost at a stage = stage cost ÷ total life cycle cost × 100.

Discounting is added in the next topic. Here money is in naira, per-unit figures are rounded once at the end, and percentages to one decimal place.

Worked examples

1. Lorry A.
   Capital 12,000,000 − 1,500,000 = ₦10,500,000.
   Services 120,000 ÷ 10,000 = 12 × 450,000 = ₦5,400,000.
   Running 120,000 × 680 = ₦81,600,000.
   Life cycle cost ₦97,500,000; per km 97,500,000 ÷ 120,000 = ₦812.50.
2. Lorry B.
   Capital 18,000,000 − 4,000,000 = ₦14,000,000.
   Services 6 × 520,000 = ₦3,120,000.
   Running 120,000 × 480 = ₦57,600,000.
   Life cycle cost ₦74,720,000; per km ₦622.67.
3. Comparison. Lorry B costs ₦6,000,000 more to buy but ₦22,780,000 less over its life. Lorry B is the better choice on cost. The comparison ignores the time value of money, which should be added when the costs fall over many years. The lorry’s reliability and availability, which should be considered too.

1. Shares.
   Development 60 ÷ 300 = 20.0%; introduction 10.0%; growth 75 ÷ 300 = 25.0%; maturity 90 ÷ 300 = 30.0%; decline 10.0%; withdrawal 15 ÷ 300 = 5.0%.
   Total 100%.
2. Committed cost.
   80% × ₦300m = ₦240m, though only ₦60m (20.0%) is spent in development.
3. Comment. The development team makes decisions that fix four-fifths of the cost, while spending a fifth. Cost control and target costing must therefore be applied at the design stage, because by maturity there is little left to save.

Expect variants: servicing by hours, a residual value that is negative (a disposal cost), different lives for the options, or running costs that rise each year.

Common mistakes

• Choosing on purchase price. The dearer asset may be cheaper over its life.
• Forgetting the scrap value or the end-of-life cost.
• Wrong number of services. Divide the life by the interval.
• Mixing stages with cost categories. Stages are in time; categories are acquisition, operating and end-of-life.
• Ignoring committed cost. Most cost is fixed by early decisions.
• Ignoring non-financial factors such as reliability and servicing time.

Quick revision

• LCC = whole life costing; total cost of ownership or of a product over its life; for asset purchases and new products.
• Categories: acquisition, operating, end-of-life. Early decisions commit most cost.
• Stages: development, introduction, growth, maturity, decline, withdrawal, with costs listed above.
• Buildings: lowest total cost or best value over the life; discount the costs.
• Compare options by life cycle cost per unit of use.

How the marks are earned

• Explain LCC: the idea, its two uses and the committed-cost point.
• List costs: one mark for each cost category or stage cost, with an example.
• Calculate: capital cost, services, running, total and per unit; then a conclusion.

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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