Life Cycle Costing

Product Life Cycle refers to common stages in the life of any product. It describes the
different phases through which a product passes from the time it was first introduced into the
market till it is withdrawn or removed from the market.

Generally, the life cycle of a product is used to mean operational life or market life which
refers to the period for which the product enjoys demand in the market from the customers.

In other words Life of a product refers to the number of years for which the product is sold.

Stages/ Phases of Product Life Cycle

Introduction Stage: This stage of the cycle could be the most expensive for a company
launching a new product. The size of the market for the product is small, which means sales
are low, although they will be increasing. On the other hand, the cost of things like research
and development, consumer testing, and the marketing needed to launch the product can be
very high, especially if it’s a competitive sector.

Growth Stage: The growth stage is typically characterized by a strong growth in sales and
profits, and because the company can start to benefit from economies of scale in production,
the profit margins, as well as the overall amount of profit, will increase. This makes it
possible for businesses to invest more money in the promotional activity to maximize the
potential of this growth stage.

Maturity Stage: During the maturity stage, the product is established and the aim for the
manufacturer is now to maintain the market share they have built up. This is probably the
most competitive time for most products and businesses need to invest wisely in any
marketing they undertake. They also need to consider any product modifications or
improvements to the production process which might give them a competitive advantage.

Decline Stage: Eventually, the market for a product will start to shrink, and this is what’s
known as the decline stage. This shrinkage could be due to the market becoming saturated
(i.e. all the customers who will buy the product have already purchased it), or because the
consumers are switching to a different type of product. While this decline may be inevitable,
it may still be possible for companies to make some profit by switching to less-expensive
production methods and cheaper markets.

Features/ Characteristics of Product Life Cycle

Stages Common Characteristics

1. Investment is made
0. Product 2. Sales have not begun
Development Stage 3. New product ideas are generated, operationalized,
and tested

1. Costs are very high

2. Slow sales volumes to start
1. Market Introduction 3. Little or no competition
Stage 4. Demand has to be created
5. Customers have to be prompted to try the product
6. Makes little money at this stage

1. Costs reduced due to economies of scale

2. Sales volume increases significantly
3. Profitability begins to rise
2. Growth Stage 4. Public awareness increases
5. Competition begins to increase with a few new
players in establishing market
6. Increased competition leads to price decreases

1. Costs are lowered as a result of increasing

production volumes and experience curve effects
2. Sales volume peaks and market saturation is
3. Maturity Stage reached
3. New competitors enter the market
4. Prices tend to drop due to the proliferation of
competing products
 5. Brand differentiation and feature diversification is
emphasized to maintain or increase market share
6. Profits decline

1. Costs increase due to some loss of economies of

scale
2. Sales volume declines
4. Decline Stage 3. Prices and profitability diminish
4. Profit becomes more a challenge of
production/distribution efficiency than increased
sales

Life Cycle Cost

The Life cycle costs represent the present values of all expenses including capital
expenditure, installation costs, operating costs, repairs and maintenance costs and disposal
costs over the life time of the product or project.

Therefore, these costs are also called cradle-to-grave costs or womb-to-tomb costs.

Product Life Cycle Cost can be defined as the total cost throughout its life including
planning, design, acquisition and support costs and any other cost directly attributable to
owning or using the assets.

According to Dhillon Life Cycle Costs as the sum of all costs incurred during the life time of
an item i.e. procurement and ownership costs.

According to Australian Standard has defined Life Cycle Cost the sum of acquisition cost
and ownership cost of a product over its life cycle.

According to Guidance on Life Cycle Cost Analysis, Life Cycle Costs as sum of the present
values of investment costs, capital costs, installation costs, operating costs, maintenance costs
and disposal costs over the life time of the project, product or measure.

Life Cycle Costing

Life Cycle Costing which is also called terotechnology aims at ascertaining the life cycle
cost of the product or asset or project.
Terotechnology deals with the technology of installation, commissioning, maintenance,
replacement and removal of plant, machinery and equipment. It also deals with the provision
of the feedback pertaining to design and operation of the same.
Life Cycle Costing can be defined as the accumulation of costs for activities that occur over
the entire life cycle of a product from inception to abandonment by the manufacturer and the
customer.
According to CIMA Life Cycle Costing as the practice of obtaining over their lifetimes, the
best use of physical assets at the lowest cost to the entity.

Broad Categories of Life Cycle Costs

1. Market Research Costs: Before undertaking the production and sale of any product, it is
necessary to undertake a comprehensive survey of market to ascertain needs and
requirement of customers, expectations of customers from the product in terms of features,
how much they are willing to pay for the product, quantity they are willing to buy,
presence of competitors- their price, product features, market served, etc, scope for
expansion etc. This is an important part as the decision of the firm depends upon the result
of the survey. All expenses incurred to complete this survey successfully fall into the
category of Market Research Costs.

2. Specification and Design Costs: Based on the market research, if the company decides to
produce the product, then it is necessary to finalise product specification and design
wherein the details such as proper drawings, process schedules, product features, inputs
and the proportion of their use in the production, expected performance of the product, etc,
are discussed, analysed and finalised. The outcome of this exercise is in the from of blue
print of the product. Research wing provides all these details after the completion of
research successfully. Expenses incurred by the firm to finalise the product specification
and design, therefore fall into the category of Specification and Design Cost.

3. Prototype Production Costs: This is the process of producing sample of the intended
product on a very small scale (not for commercial purpose) in accordance with the product
specification and design. This intends to test and trail a new design to achieve the
precision in the production of the new product. It is an opportunity for the firm to put
product specifications and design into real and working environment. The expenses
incurred by the firm for this purpose categorised as Prototype Production Costs.

4. Development Costs: The product manufactured on a very small scale basis usually does
not meet the expected product performance or features. Hence, based on this testing,
necessary changes are made to improve the utility and functional value of the product. The
 end result of this exercise to demonstrate that product meets the requirements of product
specifications and design. The expenses of all these activities are grouped as Development
Costs.

5. Manufacturing Costs: Once the product passes all these tests, then the production is
undertaken for commercial purpose. It involves the purchase and use of raw materials, use
of both the manual and mechanical labour forces for conversion of raw materials into
finished goods and all other supporting services. Therefore, all expenses incurred by the
organisation to produce the product and keep it ready for sale into the category of
Production or Manufacturing Costs.

6. Marketing Costs: With the objective of selling the product, it is necessary to incur certain
expenses to stimulate and create demand for the product and when the orders are received
from the customers, it is necessary to transport the product to the customers or to
distributors or outlets for sale to customers. Hence, all expenses incurred for this purpose
of promoting the sales and distribution of goods fall into the category of Marketing Costs.

7. Product Support Costs: Once the firm starts selling its product, it is necessary to ensure
the availability of spares and expert servicing facilities throughout the life of the product.
Hence, these expenses are grouped as Product Support Costs.

8. Costs of Withdrawal: Market life of any product is limited. That means, the products
enjoy market for limited period and this period differs from one product to another
depending upon various factors including whether the product is essential or not, whether
there are substitute products, utility of the product, functional value, etc.
For instance, if the product is essential and if there are no substitutes, it enjoys market for
a long period. However, life of the product is limited and this product life is much shorter
than the company’s life.
When the demand declines substantially and if this decline is real and permanent and if
there is no other alternative to improve the sales, then the firm is forced to withdraw its
product from the market. Even after the withdrawal, the firm has to incur certain product
support costs and also for scrapping the plant used to produce the product. Hence, these
expenses are classified as Costs of Withdrawal or Costs of Decommissioning.
Features/ Characteristics of Life Cycle Costing

1. Every product has finite life, of course, differs from one product to another. However,
every product usually passes through different phases of life viz., development,
introduction, growth, maturity, decline and withdrawal. Even the period for which a a
product stays in each phase differs from one product to another. Most importantly, the cost
pattern and revenue generation differ from one phase to another.

2. Product Life Cycle Costing aims at estimating and accumulating all items or categories of
costs over the whole life of product- (a) per-production costs such as market survey
expenses, research and development costs, product specifications and design costs,
prototype production costs, etc., (b) production costs viz., direct material costs, direct
labour costs and manufacturing overhead expenses, and (c) selling and distribution
overhead expenses, customer service costs or after sales service costs and cost of
withdrawal of products, if any.

3. Usually product earns profit during its maturity phase and the Product Life Cycle Costing
estimates and accumulates costs over its entire life cycle. Therefore, it is possible to find
out whether the firm is expected to earn higher amount of profit during the product’s
maturity phase so that both the pre-production and post production costs can be recovered.

4. The very purpose of Product Life Cycle Costing is to evaluate the profitability of the
product by comparing the life cycle cost with revenue expected to be generated by the
product during its life.

5. Patterns of cost, revenue and profit of product tend to follow predictable pattern through
different phases of product life cycle.

6. Due to the difference in the amounts of costs, revenue and profit from one phase to
another, unit profit (i.e. profit per unit of sale) differs from one phase to another phases of
product life cycle. Usually, this unit profit is high during maturity phase and very low or
negative in introductory and/ or decline phase/s.

7. Different phases in product life cycle pose different kinds of threats to the firm. Similarly,
different phases in product life cycle provide different kinds of opportunities to the firm.
Hence, there is a need to modify the strategy and use appropriate strategy for each phase to
reap the maximum benefits.
 For instance, in the decline phase, as demand starts declining, it is necessary to search for
new uses and/ or new users for the product. The firm may also try to enter into new
market. All these efforts should aim at increasing the sales. Therefore, strategy should be
revised and/ or modified depending upon the threats and/ or opportunities.

8. Formulation of appropriate strategy and implementing it systematically extends the life of

the product.

9. As each phase of product life cycle poses different types of threats and offers different
kinds of opportunities, the product requires different functional emphasis in each phase of
the product life cycle.
For instance, the emphasis should be on the research and development during the
Development Phase of product life cycle. Similarly, in the Decline Phase, emphasis should
be on the cost control to offer the product at lower price.

Turning Point Indices in Product Life Cycle Costing

1. Continuously declining growth rate in sales volume is one of the indicators. Though there
has been an increase in the sales volume, the rate of increase is declining.
For example, the sales volume which has been increasing at 12%, starts declining to 11%,
to 8.5%, to 6.25% and so on.

2. Continuously declining plant capacity utilisation and therefore, the presence of long-term
idle capacity indicates the turning point in the product life cycle.
Idle capacity refers to available capacity but not currently used. When there is a reduction
in demand (i.e. declining growth rate), the firm normally produces lower quantity than at
its full capacity resulting in the non-utilisation of a part of plant capacity.

3. Success of the product in the Growth Phase and / or Maturity Phase attracts new
competitors to enter the market with similar type of product. Some competing firms may
also come out with the improved version of the product.
Presence and / or entry of more competitors with similar or improved version of the
product acts as a right substitute for the firm’s product. As a result, the firm experiences
reduction in its market share and loss of market share to its competitors on a continuous
basis. . Presence and / or entry of more competitors and continuously declining market
share are, therefore, indicators of turning point in the product life cycle.
4. Reduction in the relative share of first time purchasers of the product in the total sales of
the product (i.e. percentages of sales to new customers to total sales of the product is
declining) indicates the turning point in the product life cycle.

5. Declining Advertising Elasticity of Demand is another indicator of turning point in the

product life cycle. It may be noted that Advertising Elasticity of Demand measures the
impact of increase or decrease in advertising expenditure on the quantity demanded.
Usually, both (i.e. advertising outlay and quantity demanded) are expected move in the
same direction- increase in advertising outlay leading to increase in the quantity demanded
and vice-versa. However, (a) lower rate of increase in the quantity demanded for a given
increase in the advertisement outlay and (b) higher rate of reduction in the quantity
demanded for a given reduction in the reduction advertisement outlay indicate the turning
point in the product life cycle.

6. Similarly, even if the firm reduces the price of its product, the reduction in the price may
not result in the proportional increase in the quantity demanded. If the rate of increase in
the quantity demanded is less than the rate of reduction in the price, and/ or if the rate of
reduction in the quantity demanded is higher than the rate of increase in the price, it
indicates the turning point in the product life cycle.

7. Further, frequent price cuts and also declining profit margin are the indicators of the
turning point in the product life cycle.
Problem No.: 1
A housewife is looking at ways of producing domestic hot water and is considering two
possibilities- an electric immersion heater having an installation cost of Rs. 1,600 and an
estimated annual electrical charges of Rs. 2,000 and a gas boiler with an installation cost of
Rs. 7,600 with an fuel bills of Rs. 800. Assuming yourself as a consultant to this cost-
conscious-housewife, advise her suitably by comparing two systems on the basis of (a) total
expenditure and (b) present value, over a five year period. Take interest at 9%. What will be
your recommendation if you consider both the equipments for an eight-year period?
Solution:
Life Cycle Cost (Rs.)
Particulars Electrical
Gas Boiler
Heater
I. Useful Life of Five Years
01. Without considering Discount Factor
Installation Charges 1,600 7,600
Annual Charges
10,000 4,000
(Rs. 2000 X 5 Years; Rs. 800 X 5 Years)
Total Life Cycle Costs (a) 11,600 11,600
02. Considering the Discount Factor:
Installation Costs 1,600 7,600
Annual Charges
7,785 3,114
(Rs. 2000 X 3.8925; Rs. 800 X 3.8925)
Total Life Cycle Costs (b) 9,385 10,714
II. Useful Life of Eight Years
01. Without considering Discount Factor
Installation Charges 1,600 7,600
Annual Charges (Rs. 2000 X 8 Years; Rs. 800 X 8 Years) 16,000 6,400
Total Life Cycle Costs (a) 17,600 14,000
02. Considering the Discount Factor:
Installation Costs 1,600 7,600
Annual Charges (Rs. 2000 X 5.541; Rs. 800 X 5.541) 11,082 4,433
Total Life Cycle Costs (b) 12,682 12,033

Based on the above calculations made and presented above, the following advises can be
offered to the cost-conscious-housewife.
1. On a Five-year useful Life
a. Both the alternatives are equally economical as both involve a total life cycle cost of Rs.
11,600 each (without considering the discount factor).
b. Electrical immersion heater should be preferred, if the decision is based on the present
value of life cycle cash outflow (Rs. 9,385 in the case of Electrical Immersion Heater as
against Rs. 10,714 for Gas Boiler).
2. On a eight year useful life, Gas Boiler should be preferred irrespective of whether cost
analysis is with or without considering discount factor- Rs. 14,000 (Boiler) against Rs.
17,600 (Heater) or Rs. 12,033 (Boiler) against Rs. 12,682 (Heater).

Problem No.: 2
Solution:
Problem No.: 3
Problem No.: 4
Solution
Problem No.: 5
Solution: