Life-cycle Costing

CIMA-P2 · Chapter 4

Life-cycle Costing

1 Introduction

Life cycle costing is the third of the value management techniques the syllabus names under P2A3. Its component outcome is A3c, and its topic is “life cycle costing and its implication for market strategies” — so the technique is only half of what is examinable here. The other half is what a business does once it has the life-cycle picture, and that is section 6.

Life cycle costing aims to ensure that the lifetime revenue of a product covers all of the costs incurred over its lifetime — not the costs of one accounting period.

It works particularly well with target costing, which acts at the design stage to reduce cost and to prevent unnecessary expenditure from being locked in. The overall life-cycle cost of a product should be lower where target costing has been applied before production begins.

Why one period is the wrong window

Almost every product loses money in its early years: the development cost is incurred before any revenue, and the introduction phase carries heavy advertising against low volume. A decision taken on next year's profit would launch nothing. A price set on next year's cost would be too high to build the volume the later years depend on.

2 What life cycle costing does

Profits are earned when total revenue exceeds total cost. Life cycle costing requires management to bring all costs — past, present and future — into that total.

It therefore encourages a long-term perspective, and includes the costs of bringing the product to market and the costs that follow its withdrawal from sale. From there management can measure the total profitability of a product and make better decisions about its production and sale.

Traditional financial accounting can cause the true lifetime cost of a product to be overlooked or understated, mainly because the associated costs fall into different accounting periods: development costs are written off as an expense of an earlier period, and the exit costs have not yet been incurred at all.

3 The product life cycle

This recording covers the whole chapter and works all three examples. Its account of the life cycle is the source of section 3's table — sales and profit phase by phase, and the reason a single period's profit is the wrong window: “if we were just looking at short-term profits, we'd never do anything, because most products are likely to lose money in the early years”.

Notice. The tape does not reach section 6. It raises the market-strategy question in passing — “there's a chapter later on pricing” — and leaves it there.

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The costs and revenues of a product differ at different stages of its life. During development, research and design costs are high while sales revenue is nil, so the product is loss-making. If costings, and the decisions based on them, took only a short-term view, poor decisions would follow.

Life cycle costing identifies the phases of the life cycle and makes management consider the different costs and revenues that arise across the whole of the product's life.

3.1 The five phases

The graph shows sales and profit against time, with a dashed line at zero. The four vertical guides mark the start of the introduction, growth, maturity and decline phases; everything to the left of the first is the development phase. Note that profit is below the dashed zero line through development and most of introduction, and that it turns down before sales do.

Phase	Sales	Profit	What is happening
Development	Nil	A loss	The product is being researched, designed and prototyped. Costs are incurred and there is no revenue at all.
Introduction	Low, growing slowly	A loss, at its deepest early on	The product goes on sale, but customers take time to become aware of it. Advertising and launch costs are heavy against low volume.
Growth	Rising steeply	Turns positive and rises	Demand takes off. Unit costs fall as economies of scale appear, so profit rises faster than sales.
Maturity	High, but no longer growing	At its highest	The market is saturated. Volumes are good and stable, development is long paid for, and this is where the product earns most of its lifetime profit.
Decline	Falling	Falling, and can turn to a loss	A newer product takes over. Unless the business withdraws, the fixed costs of continuing to produce can exceed the shrinking contribution.

Costs at each phase of the life cycle

Use the five phases of the product life cycle to suggest the typical costs that are likely to be incurred at each stage of a product's life.

Costs at each phase of the life cycle

The costs depend on the product and its market, but typical costs are as follows. Other answers are acceptable.

Phase	Typical costs
Development	Research costs, including market research. Design costs. The cost of prototyping and testing.
Introduction	Launch costs, procurement, production (materials, labour, overheads), machinery set-up, staff training, selling and distribution costs, and heavy advertising.
Growth	Continuing advertising, higher production volumes, machinery maintenance and depreciation, selling and distribution costs, the cost of product returns, and the cost of promotions.
Maturity	Production costs, continuing machinery costs and machinery replacement, selling and distribution, product returns and warranty claims, and the cost of product development aimed at extending the life cycle and taking further market share.
Decline	Environmental clean-up, decommissioning, disposal costs, and reverse logistics — the returns and transport costs of recalling inventory.

4 The life cycle cost calculation

Life cycle costing accumulates every cost attributable to a product over its life cycle. Viewed across the whole of that life, it lets management evaluate and improve the total profitability of the product line.

Life cycle cost per unit = Total costs of the product over its whole life ÷ Total units produced over its whole life

Traditional accounting can make a product's profitability look narrower than it is. Success may be judged on the current margin, computed on production costs only — which links neither the high early development costs, often written off as an expense of a prior period, nor the exit costs necessary to withdraw from the market.

Life cycle cost per unit

A company is planning a new product. Market research suggests that demand for the product would last for 5 years. At a selling price of $10.50 per unit they expect to sell 2,000 units in the first year and 12,000 units in each of the other four years.

It is estimated that the lifetime costs of the product will be as follows.

Manufacturing costs	$6.00 per unit
Design and development costs	$60,000
End of life costs	$30,000

Calculate the life cycle cost per unit and determine whether the product is worthwhile producing.

Life cycle cost per unit

	Units
Year 1	2,000
Years 2 to 5 (4 × 12,000)	48,000
Total lifetime output	50,000

	$
Manufacturing (50,000 × $6.00)	300,000
Design and development	60,000
End of life costs	30,000
Total life cycle cost	390,000

Life cycle cost per unit = $390,000 ÷ 50,000 = $7.80

At a selling price of $10.50 the product returns $2.70 a unit over its whole life, a lifetime profit of $135,000 on revenue of $525,000. It is worthwhile.

The product will not be profitable in year 1: 2,000 units at a $4.50 manufacturing margin is $9,000 against $60,000 of development cost already spent. A decision taken on year 1 alone would reject a product worth $135,000. That is the whole argument for the technique.

5 Maximising profit over the life cycle

Applying the life cycle model to its own products lets a business take four kinds of action. Each of them changes the shape of the curves in section 3.

Action	What it means	Effect on the life cycle
Design costs out of the product	Act at the design stage to minimise future costs — design for future compatibility, build in quality so that warranty claims fall, use materials that reduce waste and disposal cost at the end of life. This is target costing (chapter 3) applied over the whole life.	Lowers the whole cost curve, and particularly the decline-phase costs that are easiest to forget.
Minimise the time to market	Shorten the period between conception and launch. That period is loss-making by definition, and a product that is late may meet competition that was not there when it was designed.	Shortens the development phase, so revenue starts sooner and the deepest part of the loss is shorter.
Minimise the break-even time	Reach the point at which cumulative revenue covers cumulative cost as early as possible — by launching well, by pricing to build volume, and by keeping launch costs proportionate.	Moves the point at which the profit curve crosses zero to the left, which increases the number of profitable years.
Maximise the length of the life span	Keep the product selling for as long as possible in the maturity phase, where costs are low and profits are stable — by reducing price, finding new markets, increasing promotion, or refreshing the product.	Extends the maturity phase, which is where most of the lifetime profit is earned.

6 Life cycle costing and market strategies

The syllabus topic is “life cycle costing and its implication for market strategies”, and the implication is a question of timing: which pricing and marketing strategy suits which phase, and how the expected length of the life cycle decides between them. The pricing strategies themselves are chapter 14; what belongs here is the life-cycle judgement.

6.1 Strategy by phase

Phase	Marketing emphasis	Pricing implication
Introduction	Build awareness and secure distribution.	The strategic choice is made here — skim or penetrate (section 6.2). Whichever is chosen, the price is being set against a cost that has not yet fallen.
Growth	Build market share before competitors arrive; widen the range.	Prices typically ease as competition appears and as unit costs fall with scale. A skimming price is stepped down through this phase.
Maturity	Defend share; differentiate; find new segments and new uses.	Price competition is at its sharpest. Cost leadership matters most here, which is where the whole of section A earns its place.
Decline	Harvest, or withdraw.	Price to clear inventory and to recover the exit costs. The decision is whether the remaining contribution covers the cost of continuing to produce at all.

6.2 Skimming or penetration — and how the life cycle decides

	Price skimming	Penetration pricing
What it is	Launch at a high price to the customers least sensitive to price, then step the price down as the market widens.	Launch at a low price to build volume and market share quickly.
It suits a product with	A short expected life; protection from imitation (a patent, a brand, a technical lead); early adopters willing to pay; and high development cost to recover quickly.	A long expected life; strong economies of scale; price-elastic demand; and a market where being first to scale deters entrants.
What it does to the life cycle	Recovers the development cost early, so the break-even point comes sooner. Volume, and therefore lifetime profit, is lower.	Delays break-even but lifts volume for the whole of the life, so the life cycle cost per unit is lower and lifetime profit is higher.
The risk	A high price invites entry and slows the growth phase; if imitation comes quickly the high-margin years are few.	If the life turns out to be shorter than expected, the development cost may never be recovered.

The trade-off, with numbers

A product costs $600,000 to develop and $8 a unit to make. Two launch strategies are under consideration for an expected four-year life.

	Skimming	Penetration
Year 1 price / volume	$30 / 20,000 units	$14 / 45,000 units
Years 2–4 price / volume	$16 / 40,000 units a year	$14 / 70,000 units a year
Year 1 contribution	20,000 × $22 = $440,000	45,000 × $6 = $270,000
Years 2–4 contribution	3 × 40,000 × $8 = $960,000	3 × 70,000 × $6 = $1,260,000
Lifetime contribution	$1,400,000	$1,530,000
Less: development cost	($600,000)	($600,000)
Lifetime profit	$800,000	$930,000
Total lifetime units	140,000	255,000
Life cycle cost per unit	$12.29	$10.35
Cumulative break-even	1.5 years	1.8 years

Over four years penetration is worth $130,000 more and gives a life cycle cost per unit almost $2 lower, because the fixed development cost is spread over 255,000 units rather than 140,000.

Now change one assumption. If the life turns out to be two years rather than four, skimming returns $760,000 − $600,000 = $160,000 and penetration returns $690,000 − $600,000 = $90,000. The ranking reverses.

That is the implication the syllabus is asking for. The choice of market strategy is not a marketing preference: it follows from the expected length of the life cycle, and the life-cycle model is what makes the expectation explicit enough to argue about.

7 Benefits of life cycle costing

It encourages longer-term product evaluation, which single-period financial accounting conventions tend to obscure.
It supports proactive sales and marketing action to increase product profitability — sections 5 and 6.
It gives better visibility of the total profitability of a product, which allows comparison between products and a better overall view of performance.
Management become aware of the cost consequences and cost implications of earlier decisions.
Management can learn from previous products and from feedback taken over a longer horizon — for example, whether the measures taken at design stage actually reduced the cost they targeted.
It encourages higher quality, more environmentally sound output and greater innovation, because the investment made in development to reduce later costs is now visible as a benefit rather than as a cost of the current period.
The model can be adapted so that future costs and revenues later in the life cycle are discounted, reflecting the time value of money — chapters 11 and 12 supply the mechanics.

8 Customer life cycles

The customer life cycle describes the phases a customer relationship passes through. The longer a customer is retained in the most profitable phases, the greater the total profit from that customer. Identifying the phases lets a business plan targeted marketing aimed at maximising the return — and it is the same argument as the product life cycle, applied to a different object.

The customer life cycle

Required:

Explain, with examples, why a customer may not be profitable to a business in the early stages of a relationship.
Suggest methods a business could use to lengthen the period of time customers spend in the profitable phase.

The customer life cycle

(a) Customers may not be profitable in the early stages of the relationship. The cost of promotions, introductory discounts and the other expenses necessary to acquire a new customer may outweigh the revenue received from them initially. Winning a large customer often means granting a substantial opening discount, and serving them heavily while the relationship is established.

(b) Customers who are retained should increase in profitability. They need to be held in the profitable phase for as long as possible — ideally indefinitely. At that point they are fully engaged with the product or service, repeat sales and further purchases are likely, and there is the prospect of new customers arriving through their recommendations.

Methods of maintaining that phase include increasing loyalty rewards, targeted offers, service contracts and tie-ins, unique compatibility between the business's products, and further enhancement of the features customers actually value. Better service is the simplest of them: a customer who is well served has less reason to look elsewhere.

Chapter 1's customer profitability analysis is the measurement side of the same idea, and its Example 5 — the student bank account — is the standard illustration of a deliberately loss-making acquisition.

Life cycle costing totals every cost a product causes across its whole life — development, production, and the end-of-life costs that a single period never shows — and divides by lifetime output. Its point is that almost every product loses money early, so a decision or a price based on one period is the wrong decision or the wrong price. The five phases are development, introduction, growth, maturity and decline, and profit turns down before sales do. Management act on the model by designing cost out, shortening the time to market, shortening the break-even time and lengthening the maturity phase. And the market strategy follows from the model: a long expected life argues for penetration pricing and a low life cycle cost per unit, a short one argues for skimming and early recovery of the development cost.

9 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s key terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.

Answer the questions one at a time. Your progress is saved so you can leave and come back.

Open chapter practice