Q&A-LIFE CYCLE COSTING

QUESTION ONE: SOLARIS

QUESTION TWO:MP3 PLAYERS
A company manufactures MP3 players. It is planning to introduce a new model and development will begin
very soon. It expects the new product to have a life cycle of 3 years and the following costs have been
estimated.

Year 0 Year 1 Year 2 Year 3

Units manufactured and sold 25,000 100,000 75,000
Price per unit $90 $80 $70
R&D costs $850,000 $90,000 - -

Production costs
Variable cost per unit $30 $25 $25
Fixed costs $500,000 $500,000 $500,000
Marketing costs
Variable cost per unit $5 $4 $3
Fixed costs $300,000 $200,000 $200,000

Distribution costs
Variable cost per unit $1 $1 $1
Fixed costs $190,000 $190,000 $190,000
Customer service costs per $3 $2 $2
unit
Required
a) Explain life cycle costing and state what distinguishes it from more traditional management
accounting techniques. (10 marks)
b) Calculate the cost per unit looking at the whole lifecycle and comment on the price to be charged.
(7 marks)
c) Briefly explain how can an organization maximize the return over the product life cycle
SUGGESTED SOLUTION
QUESTION THREE ( PQ )- CIMA P2 MAY 2010
PQ manufactures and sells consumer electronics. It is constantly working to design the latest gadgets and
“must-haves” which are unique in the market place at the time they are launched. The management of PQ
are aware of the short product life cycles in this competitive market and consequently use a market
skimming pricing strategy at the introduction stage.
Required:
Explain the changes that are likely to occur in the following items at the three later stages in the product
life cycle of a typical PQ product.
i) Selling price
ii) Production costs
iii) Selling and marketing costs

ANSWERS
i) Growth Stage
Compared to the introduction stage the likely changes are as follows:
Unit selling prices
These are likely to be reducing for a number of reasons:
 The product will become less unique as competitors use reverse engineering to
introduce their versions of the product
 PT may wish to discourage competitors from entering the market by lowering the price
and thereby lowering the unit profitability
 The price needs to be lowered so that the product becomes attractive to customers in
different market segments thus increasing demand to achieve growth in sales volume.
Unit production costs
These are likely to reduce for a number of reasons:
 Direct materials are being bought in larger quantities and therefore PT may be
able to negotiate better prices from its suppliers thus causing unit material
costs to reduce
 Direct labour costs may be reducing if the product is labour intensive due to
the effects of the learning and experience curves
 Other variable overhead costs may be reducing as larger batch sizes reduce
the cost of each unit
 Fixed production costs are being shared by a greater number of units.

ii) Maturity Stage

Compared to the growth stage the likely changes are as follows:
Unit selling prices
These are unlikely to be reducing any longer as the product has become established in the
market place. This is a time for consolidation and while there may be occasional offers to tempt
customers to buy the product the selling price is likely to be fairly constant during this period.
Unit production costs
Direct material costs are likely to be fairly constant in this stage. They may even increase as
the quantities required diminish compared to those required in the growth stage, with the
consequential loss of negotiating power.
Direct labour costs are unlikely to be reducing any longer as the effect of the learning and
experience curves has ended. Indeed the workers may have started working on the next
product so that their attention towards this product has diminished with the result that direct
labour costs may increase.
Overhead costs are likely to be similar to those of the end of the growth stage as optimum
batch sizes have been established and are more likely to be used in this maturity stage of the
product life cycle where demand is more easily predicted
QUESTION FOUR(DTG) –CIMAP2 SEPT 2011
DTG is a management accounting consultancy that specialises in providing services to small businesses
that do not have in-house expertise in management accounting techniques. Its clients vary in size and
operate in many different sectors including manufacturing, retail and service industries. Although they are
different, all clients require similar services most of which are provided by DTG’s team of employed
accountants and support staff. Occasionally DTG will engage the services of specialists on a one-off
contract basis to help to solve the problem faced by a particular client.
Before accepting clients, DTG will meet with them to discuss their requirements and to agree the basis of
their fees.
DTG has an ongoing relationship with many of its clients. This level of involvement within the client’s
business enables DTG to foresee potential problems for the client and offer further services. This works
well for the clients and particularly well for DTG who gain a considerable number of new assignments in
this way.
New clients tend to be initially for “one-off” assignments. Working with new clients requires time and effort
to be invested to become familiar with the client’s business and procedures. DTG hopes to form a
relationship and attract more assignments and referrals from each client it works with.

Required:
Explain how Customer Life Cycle costing could be used by DTG.

ANSWER TO QUESTION THREE (DTG)

Life cycle costing collects the costs of the cost object (each client in DTG’s case) over their lifetime,
irrespective of accounting years. This allows the total profit of each client to be measured.

DTG would need to set up a system to record the time spent, its cost, the cost of disbursements and the
fee income derived from its client so that these values could be accumulated over the client’s lifetime.
This would start with the initial meeting with the potential client because although this cost could not be
charged to the client it is still a cost that has been incurred. If they become a client then other costs will be
incurred in setting them up on the system as a client. At this stage no fee income has been earned because
no services have yet been provided so the client is loss making. DTG would hope to gradually recover
these initial costs by providing services until the client becomes profitable to them.

For those clients where DTG is being engaged on a one-off basis for each assignment there will be non-
chargeable set up costs before each assignment is agreed. These costs need to be reflected in the fees
charged for the services that are to be provided. Where a continuous role is agreed then discounted fee
rates may be applied to recognise the reduced amount of setup costs.

DTG will also need to record the cost of time spent on non-chargeable activities after the service has been
provided such as chasing the client for payment. They will also need to record the value of referrals that
the client has made to them. This is often difficult to measure but may perhaps be identified by the smaller
amount of time required to convert a lead from an existing client into a new client compared with the time
required to convert other prospects into clients.

DTG can then measure the profits of each of its clients since their initial appointment and consequently
determine which of them are most and least profitable.
QUESTION FIVE: CAMBS CO.
Cambs Co is an innovative, high technology company which has recently completed the development and
testing of a new product, the Fentiger. The development of the product has cost $500,000 and the company
has also bought a machine to produce the new product costing $175,000. The production machine is
capable of producing 1,500 units of Fentigers per month and is not expected to have a residual value due
to its specialised nature.
The company has decided that the unit selling prices it will charge will change with the cumulative numbers
of units sold as follows.

Cumulative sales units

Selling price
$ per unit in this band
0 to 1,900 120
1,901 to 4,900 90
4,901 to 13,400 60
13,401 to 73,400 50
73,401 and above 40

Based on these selling prices, it is expected that sales demand will be as shown below.

Months Sales demand per month

(units)
1 – 10 190
11 – 20 300
21 – 30 850
31 – 70 1,500
71 – 80 900
81 – 90 700
91 – 100 450
101 – 110 300
Thereafter NIL

Unit variable costs are expected to be as follows.

$ per unit
First 1,900 units 50
Next 11,500 units 40
Next 30,000 units 30
Next 30,000 units 25
Thereafter 30
Cambs Co operates a Just in Time (JIT) purchasing and production system and operates its business on a
cash.

Required
a) Explain each stage in the life cycle of the Fentiger and the issues that the management team will
need to consider at each stage. Your answer should include a diagram to illustrate the product life
cycle of the Fentiger. (10 marks)
b) Calculate the total cash flow expected from the production and sale of Fentigers and briefly
comment on your calculations. (6 marks)
c) Briefly explain the advantages of lifecycle costing. (4 marks) (Total = 20 marks)
SUGGESTED ANSWERS- Cambs Co

Top tips.
 Part (a) is a straightforward explanation of the stages of the life cycle but you must apply
your explanation to the specific organisation in the question and use the information about
the Fentiger to illustrate your explanation.

 Part (b) is a relatively simple calculation, provided you read the information provided
carefully and set out the calculations in a clear table.

 Part (c) is again a straightforward explanation of points which you should have revised and
learnt.

ANSWERS
a)
The life cycle is divided into a number of distinct stages, although the time span of each stage can vary
significantly for different products.
The current tendency is towards shorter product life cycles and this is particularly the case for products
in the high-technology sector. Products becomes rapidly outdated by new technological developments and
competitors are quick to launch their own, better versions of products.

Stages in the product life-cycle of the Fentiger

i) Development
During this stage the product is not earning revenue but high levels of costs are being incurred
on research and product development and possibly on assets for production. For Cambs Co,
these costs amounted to $675,000.
A very high proportion of the product's costs will have been determined by decisions made
early in the life cycle, at the development stage. Life-cycle costing and target costing are
particularly useful at this stage to ensure that costs will be kept to a minimum over the product's
life cycle.

ii) Introduction
This stage represents a period of high business risk and Cambs Co should expect negative net
cash flow.
Customer interest in the product should be high given the novelty of the product. The level of
initial sales achieved will very much depend on the amount of advertising and promotion.
For Cambs Co, costs are high at $50/unit and the selling price is also (compared with those
over the entire lifecycle) high at $120/unit. A unit contribution of $70/unit sold is the highest
contribution over the product life cycle. Cambs Co therefore appears to be seeking to recoup
as much R&D expenditure and non-current asset expenditure as possible at this stage.
The sooner the Fentiger is launched, the quicker its research and development costs will be
repaid, providing Cambs Co with funds to develop further products. At this stage in its life cycle,
growth in sales is the key performance measure.

iii) Growth
The growth stage typically shows a rapid increase in sales. From month 11 to 30, growth in
sales of Fentigers is expected to increase rapidly so this is probably the growth stage for this
product. The product should by now be making a profit, although much of the cash it generates
may be being used for expansion. The aim during this stage is to build market share. Costs
will still be high as more promotion is needed to advertise the product more widely.
Distribution channels may be expanded to take up more market share. The price will be high
but may need to fall if demand is seen as falling. Cambs Co charges between $60 and $90/unit
sold and the price drops over the period in response to market conditions. However, the unit
variable cost is also falling. Margins are falling but volume has risen so the product is
contributing more at this stage than the last one.
 By now competitors may be in the process of developing or even launching competing
products, and so management should be analysing their marketing strategies.

iv) Maturity
The rate of sales growth slows down during this period and the Fentiger will reach a period of
maturity. Cash flow should be positive and profits should be good. This is the most profitable
stage of the product's life cycle. Costs will continue falling as economies of production are
achieved.
Advertising costs should fall as product awareness is stronger. Marketing is concentrated in
reaching new customers. The price will fall in response to competition and to retain market
share. From the demand figures, it looks as though this is expected in months 31 to 70. Using
the cash flows generated by the Fentiger, Cambs Co should have developed and be ready to
launch an updated version of, or the successor to, the Fentiger. (Unless driven by competitors'
actions, Cambs Co should guard against product proliferation (launching an updated
version or a successor too quickly), however, as the Fentigers' life cycle would be cut short and
it may only just cover its development costs).

v) Decline
This is the stage at which the product is losing popularity and market share is falling. Cambs
Co can adopt a choice of strategies including running the product down or discontinuing it.
Costs fall as marketing support is withdrawn but economies of scale begin to decline so the
unit variable cost actually rises again to $30/unit. Prices are reduced to mop up market
share.
 b) Costs of product life cycle

Months 1-10 11-20 21-30 31-70 71-80 81-90 91-100 101-110

Number of 1,900 3,000 8,500 60,000 9,000 7,000 4,500 3,000

unitsproduced
and sold

$ $ $ $ $ $ $ $

Selling price 120 90 60 50 40 40 40 40

per unit
30

Unit variable 50 40 40 30 &25 30 30 30

cost W1)

Unit 70 50 20 10 20 & 10 10 10
contribution 25
(W1)

Total 133,000 150,000 170,000 1,350,000 70, 000 45,000 30,000

contribution 90,000

Cumulative (542,000) (392,000) (222,000) 1,128,000 1,218,000 1,288,000 1,333,000 1,363,000

cash
flow(W2)

Workings
1. (30,000 �$20) + (30,000 �$25) = $1,350,000
2. The initial cash outflow of $500,000 + $175,000 is deducted from the cash inflows. Fentigers are
expected to generate a positive cash inflow of $1,363,000 over the product's life cycle. As
expected from the life cycle analysis outlined in part (a), Cambs Co does not make a profit from
Fentigers in the introductory stage. It should be expected to start making a profit in the growth
stage but this does not actually happen until the product reaches maturity in months 31 to 70.
Cambs Co may want to look at reducing costs or raising prices further in the early stages of the life
cycle.
 c) Advantages of life cycle costing
The advantages of lifecycle costing arise due to the fact that actual costs and revenues attributable to
each product are tracked and accumulated over the entire product life cycle. This means that the total
profitability of any product can be determined.

Research and development costs

Traditional cost accumulation systems do not tend to relate research and development costs to the
products that caused them. Instead they write off these costs on an annual basis against the revenue
generated by existing products. This makes the existing products seem less profitable than they really
are.

If research and development costs are not related to the causal product the true profitability of that product
cannot be assessed.
With life cycle costing, non-production costs are traced to individual products over complete life cycles.
The total of these costs for each individual product can therefore be reported and compared with revenues
generated in the future and the visibility of such costs is increased.

Impact on product profitability information

Individual product profitability can be better understood by attributing all costs to products and, as a
consequence, more accurate feedback information is available on the organisation's success or failure
in developing new products.

Significance of planning, design and development

In order to compete effectively in today's competitive market, organisations need to redesign continually
their products with the result that product life cycles have become much shorter. The planning, design
and development stages of a product's cycle are therefore critical to an organisation's cost
management process. Cost reduction at this stage of a product's life cycle, rather than during the production
process, is one of the most important ways of reducing product cost.
An understanding of the product life cycle emphasis the need to minimise the time to market and
minimize the breakeven time. It also encourages organisations to aim to maximise the length of the life
span.