CA Megh Raj Aryal Gurukul CA

CHAPTER 15– LIFE CYCLE COSTING

Chapter Learning outcomes

1. Meaning of Product Life Cycle.
2. Phases in Product Life Cycle
3. Characteristics of Product Life Cycle concept.
4. Stages in Product Life Cycle
5. Meaning of Life Cycle Costing
6. Benefits of Life Cycle Costing
7. Life Cycle Profitability

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Concept
• Normally operating statement/ income statement is prepared for a certain period. (usually one year). The operating
revenue , operating cost and operating profit for the certain period (year) is reflected under this statement.
• However, Life cycle costing is the cost ascertainment of a product, project over its projected entire life. [ie from
inception to decline]
• It is the sum of all recurring and onetime costs over the full life span of the product.
• The life cycle cost includes:
- R&D cost, Design cost, Fixed assets purchase cost and installation cost
- Operating (manufacturing cost), maintenance and upgrade cost
- Selling and Distribution costs, post sale service cost including warranty cost and
- Product take back and abandonment cost (environmental clean-up disposal and decommissioning costs) and
residual value at the end of its useful life.
• Life cycle costing is also known as “cradle to grave costing” or “womb to tomb costing”.

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 Practical problems
Q.1. TCS a computer software company is developing a new accounting packages, "General ledger" The following
budgeted information for general ledger over a 6-year product life cycle are given:
Year 1 and 2
R & D Costs Rs.2,40,000
Design cost Rs 1,60,000
Year 3 to 6: Other Functional costs
One-time setup costs Cost-per package
Production costs Rs.1,00,000 Rs.25
Marketing costs Rs 70,000 Rs 24
Distribution costs Rs 50,000 Rs 16
Customer-service costs Rs 80,000 Rs 30

The sales quantity during the Product Life Cycle at various selling prices are:
S.P. per package Rs.400 Rs.480 Rs.600
Sales quantity (in units) 5,000 4,000 2,500

Ignoring time value of money, compute the net incomes generated over the product life cycle at various prices.
Which price should the company select? [Ans: Profit Rs 825,000, Rs 840,000, Rs 562,500]

Q.2. Polaris, a company engaged in Decision Support Systems (DSS) is examining the profitability and pricing policies of
three of its recent engineering software packages:
• EE -46: Package for electrical engineers
• ME-83: Package for mechanical engineers
• IE -17: Package for industrial engineers.

Summary details on each package over their two-year “cradle-to-grave" product lives are as follows:
Number of Units sold
Package Selling Price Year 1 Year 2
EE-46 Rs 250 2,000 8,000
ME-83 Rs 300 2,000 3,000
IE -17 Rs200 5,000 3,000

Assume that no inventory remains on hand at the end of year 2.

Polaris is deciding which product lines to emphasize. In the past two years, profitability has been mediocre. Polaris is
particularly concerned with the increase in R & D costs. An analyst pointed out that for one of its most recent
packages (IE-17), major efforts had been made to reduce R&D costs.

Praveen, the engineering software manager, decides to collect the following life-cycle revenue and cost information
for the EE - 46, ME- 83, and IE-17 packages:
EE-46 ME--83 IE-17
Year 1 Year 2; Year 1 Year 2 Year l Year 2
Revenues Rs 500,000 Rs 20,00,000 Rs 600,000 Rs 900,000 Rs 10,00,000 Rs 600,000
Costs
R&D 700,000 0 450,000 0 240,000 0
Design of product 185,000 15,000 110,000 10,000 80,000 16,000
Manufacturing 75,000 225,000 105,000 105,000 143,000 65,000
Marketing 140,000 360,000 120,000 150,000 240,000 208,000
Distribution 15,000 60,000 24,000 36,000 60,000 36,000
Customer service 50,000 325,000 45,000 105,000 220,000 388,000

Required:
a) Present a product life- cycle income statement for each software package. Which package is the most
profitable, and which is the least profitable? Ignore the time value of money.
[Ans: EE-46 Rs 350,000, ME-83 Rs 240,000, IE-17 (Rs 96,000)]
b) How do the three software packages differ in their cost structure (the percentage of total costs in each cost
category)?

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Q.3. Timex makes digital watches. Timex is preparing a product life-cycle budget for a new watch, MX3. Development on
the new watch is to start shortly. Estimates for MX3 are as follows:
Life- cycle units manufactured and sold 400,000 units
Selling price per watch Rs 40
Life-cycle costs
R&D and design costs! Rs 10,00,000
Manufacturing
Variable cost per watch Rs 15
Variable cost per batch Rs 600
Watches per batch 500 units
Fixed costs Rs 18,00,000
Marketing
Variable cost per watch Rs 3.20
Fixed costs Rs 10,00,000
Distribution
Variable cost per batch Rs 280
Watches per batch 160 units
Fixed costs Rs 720,000
Customer-service cost per watch Rs 1.50

Ignore the time value of money.

Required
(i) Calculate the budgeted life-cycle operating income for the new watch. [Ans: Rs 24,20,000]
(ii) What percentage of the budgeted total product life-cycle costs will be incurred by the end of the R&D and
` design stages? [Ans: 7.36%]
(iii) Timex’s market research department estimates that reducing MX3's price by Rs 3 will increase life cycle unit
sales by 10%. If unit sales increase by 10% Timex plans to increase manufacturing and distribution batch sizes
by 10% as well. Assume that all variable costs per watch, variable costs per batch, and fixed costs will remain
the same. Should Timex reduce MX3's price by Rs 3? Show your calculations. [Ans: 19,12,000, No ]

Q.4. A company is planning to come out with a new product which will have life cycle of 3 years. You have been asked to
prepare a Life cycle budget with the help of given details:
Particulars Year 1 Year 2 Year 3
Expected sales volume 10,000 18,000 6,000
Marketing costs Rs 1,00,000 50,000 Nil

Development and design cost would be Rs 5,00,000. SP Rs 35 per unit. The expected total production costs per year:
Output 10,000 units Cost Rs 1,30,000
Output 15,000 units Cost Rs 1,60,000
If the volume crosses 17,000 units level, the fixed cost increases by 40%.
Will the company shall be able to earn a net profit of 20% on sales? [Ans: Profit % of sales 8.24%]

Q.5. Madhav Ltd. Is considering developing two new products, A and B. The management Accountant presents the
following Life cycle Budget for the two products: (Rs)
Particulars Product A Product B Total
Sales 50L 60 L 110 L
Cost of goods sold 25 L 30L (55 L)
Gross profit 25 L 30 L 55 L
R & D cost ( 20 L)
Marketing cost ( 5.5 L)
Designing costs ( 13 L)
Profit 16.50 L
The chairman does not approve the project as the company’s policy is that net profit should be at least equal to 16% of
sales. He is willing to go for the either of the two products if the company’s policy is adhered to. The management
Accountant finds that 60% of R and D costs, 40% of marketing costs and 30% of the designing costs are incurred for
A and balance for B. Advise the chairman. [Ans: A 13.8%, B 16%]

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Q.6. Y-Connections, China based firm, has just developed ultra-thin tablet S-5 with few features like the ability to open two
apps at the same time. This tablet cost Rs 5,00,000 to develop; it has undergone extensive research and is ready for
production. Currently, the firm is deciding on plant capacity, which could cost either Rs 35,00,000 or Rs 52,00,000.
The additional outlay would allow the plant to increase capacity from 500 units to 750 units. The relevant data for the
life cycle of the tablet at different capacity level are as under:
Expected Sales 500 units 750 units
Sale Price Rs 79,600 per unit Rs 69,600 per unit
Variable Selling Costs 10% of Selling Price 10% of Selling Price
Salvage Value - Plant Rs 6,25,000 Rs 9,00,000
Profit Volume Ratio 40%
Required:
Advise Y – Connections, regarding the optimal plant capacity to install. The tablet’s life cycle is two years. Ignore
time value of money. [Ans: Cap 500 units Profit Rs 125,45,000, Cap 750 units Profit Rs 123,30,000]

Q.7. Activities have been identified and the budget quantifies for the three months ended 31 March 2001 as follows:
Activities Cost Driver Units of Cost
Unit basis Cost Driver (Rs000)
Product Design Design hours 8,000 2000 (See note1)
Purchasing Purchase order 4,000 200
Production Machine hours 12,000 1500 (See note 2)
Packing Volume(Cu.m) 20,006 400
Distribution Weight (Kg) 1,20,000 600
Note 1:- This includes all design costs for new products released this period.
Note 2:- This includes a depreciation provision of Rs 300,000 of which Rs 8000 applies to 3 months depreciation on
a straight line basis for a new product (NPD). The remainder applies to other products.

New product NPD is included in the above budget. The following additional information applies to NPD.
(i) Estimated total output over the product life cycle: 5,000 units (4 years life cycle)
(ii) Product design requirement : 400 design hours.
(iii) Output in quarter ended 31 March 2001:250 units
(iv) Equivalent batch size per purchase order: 50 units.
(v) Other product unit data: production time 0.75 machine hours: volume 0.4 cu. meters: weight 3 kg.
Required:
Prepare a unit overhead cost for product NPD using an activity based approach which included an appropriate share
of life cycle costs using the information provided in above. [Ans: Rs 144.6/unit]

Q.8. Quickcomp is a successful version of a software package that is widely used. Fastercomp is the next version., for
which the development is complete and it is ready to be sold immediately in the market as budgeted. However, for
Fastercomp, user manuals, training modules and diskette have not yet been made, whereas, for the Quickcomp version,
these are overstocked by 5,000 units. Release of Fastercomp, version will render the Quickcomp version not saleable.
The following information is provided:
Particulars Quickcomp Fastercomp
Selling price per unit (Rs) 14,000 19,000
Variable cost per unit (Rs) (consisting of user manuals, training modules and 1,000 4,000
diskettes)
Development Cost per unit (Rs) (total cost of development spread over the 7,000 10,000
expected sales quantity during the products’ life-cycle)
Marketing/ Administration Cost per unit (Rs) ( Fixed budgeted annual 3,500 4,000
outflow divided by the expected sales quantity for each product for the year)
Total Cost per unit Rs 11,500 18,000
Operating Income per Unit (Rs.) 2,500 1,000
From a purely financial perspective, the company wants your advice whether to delay the release of the new version
by 2 months by when the inventory of the existing version would have sold out or to release the new version
immediately. Support your advice with relevant figures.
[Ans: Release New faster com immediately, Net benefit Rs 50 lakh]

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Q.9. A Company proposes to replace its old and obsolete machine. Two models of machines available are as under:
(i) Automatic machine involving an initial capital outlay of Rs. 5,00,000. The annual operating cost of this
model is Rs.1,50,000. Salvage value at the end of its life of 5 years is Rs. 20,000.
(ii) Semi Automatic machine involving an initial capital cost of Rs. 3,00,000. The annual operating cost is Rs.
2,10,000. Salvage value at the end of its life of 5 years is Rs. 10,000.
The company's cost of capital is 14%. Which alternative is preferred? Ignore tax.
[Ans: PV of cash outflow Automatic machine Rs 675,000, Semi Automatic machine Rs 816,626]

Q.10. XYZ Ltd supports the concept of Life Cycle for new investment decisions. The company is to replace a machine.
Two models are available in the market which will serve the purpose of the company. The details are as follows:
Particulars Model AB Model CD
Life 10 years 5 years
Cost Rs 19,000 Rs 13,000
Scrap value Rs 3,000 Rs 3,000
Annual time overhaul cost Rs 2,000 Rs 2,600
One time overhaul cost Rs 4,000 ( end of 8th year) Rs 2,000 ( end of the 4th year)
Cost of funds 10% 10%
If CD is chosen, it is likely that it would be replaced at the end of 5 years by another CD machine. Recommend, which
machine should be purchased?
[Ans: Annualized equivalent cash outflow Model AB Rs 5207.5, Model CD Rs 5898.32]

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 THEORY

Q.1. What is the meaning of Product Life cycle ?

Ans:
1. Product life cycle is a pattern of expenditure, sales level, revenue and profits over the period from new idea
generation to the deletion of product from product range.
2. Product life cycle spans the time from initial R&D on a product to when customer servicing and support is
no longer offered for the products.
3. For example, Cell phones, Motor vehicles, Computer Software, Pharmaceutical products etc have defined
product life cycle.

Q.2. Briefly explain the phases in the Product Life cycle.

Ans:
Every product has 4 phases during its entire life cycle. They are as under:
Phases Introduction Growth Maturity Decline
Sales volume Low sales Rise in increasing rate Rise in decreasing rates Declining Sales
Prices High [if skimming pricing] High Cost +Normal mark up Nearer to cost
Low [If penetration pricing]
Going rate
Costs High Cost per unit Average cost per unit Low cost per unit Low cost per unit
Profit Nil or Loss Rising profit High profit Declining profit
Competitors Few Rising number Majority Declining Number

Q.3. What are the characteristics of Product Life Cycle concept?

Ans:
1. Finite lives: Each and every product have finite lives and pass through different phases [Introduction,
Growth, Maturity and Decline]
2. Predictable course: Each and every product cost, revenue and profit patterns tend to follow predictable
course though the PLC. [Eg Profit first appear during the growth phase, optimum during the maturity phase,
declines at the point of deletion.
3. Profit per unit varies : Profit per unit varies as products move through their life cycles.
4. Different opportunities and threats: Each phase of the PLC poses different opportunities and threats that
give rise to different strategic actions.
5. Different functional emphasis in each phase: Product require different functional emphasis in each phase,
eg R &D emphasis in development phase, profit emphasis in maturity phases, cost control emphasis in the
decline phase etc.
6. Increase consumption may increase the life of product: Finding new uses or new users will extend the
life cycle of the product.

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Q.4. A company’s four products, M, N, O and P are in the market. Identify the phase of life cycle for each product
with a brief reasons:
M There is a lot of competition. Quantity sold has been increasing at 10%, 8% and 7% in the last
three years.
N Until last year, N had no competition. Suddenly the company finds 4 new products very similar to
N in the market. However, N continues to have good sales.
O There is intense competition. Achieving targeted sales is becoming increasingly difficult. Hence, the
company is introducing slightly modified features in the market.
P Huge inventory of P is available. P is being sold, but there are many products in the market which
are priced lesser than P, but have the same utility as P.

Ans:
Products Stage Reasons
M Maturity Rise in sales at decreasing rates, fierce competition
N Growth Rising no of competitors, increase in sales
O Maturity Intense completion, Facing competition by introducing modified products
P Declining Huge inventory, Availability of cheaper substitutes.

Q.5. Explain the various stages in Product Life cycle

Ans:
1. Market research : To establish what product the customer wants? How many units customer will buy?, How
much he is prepared to pay?
2. Design specification: Customer requirements are translated into product specifications.[ required life,
maintenance cost, maximum permissible manufacturing cost, required performance of the product etc]
3. Design: To create the drawing which define the product and the manufacturing processes .
4. Prototype manufacture: To produce a small quantity of the product.
5. Development: To analyze, test and modify the prototypes, till it satisfies the specification requirement.
6. Tooling: To arrange production line of necessary machines and equipments.
7. Manufacture: This involves manufacturing of product.
8. Selling : To create demand and awareness of the product, advertisement, campaign etc
9. Distribution: To distribute the products from production centres to various locations, sales outlets, customers,
markets through appropriate distribution channels.
10. Product support: Servicing, parts replacement during the life of the product.
11. Decommissioning or Replacement: Once the product comes to an end, the plant used to build the product must
be re-used, sold, scrapped, or decommissioned in a way that is acceptable to society.

Q.6. What is the product life cycle costing? What are the costs that you would include in the product life cycle cost?
Ans:
1. Life cycle costing is the cost ascertainment of a product, project over its projected entire life.
2. It is the sum of all recurring and onetime costs over the full life span of the product.
3. Life cycle costing is also known as “cradle to grave costing” or “womb to tomb costing”.
4. The life cycle cost includes:
o R&D cost, Design cost, purchase cost, installation cost
o Operating (manufacturing cost), maintenance and upgrade cost
o Selling and Distribution costs, post sale service cost including warranty cost and
o Product take back and abandonment cost(environmental clean-up disposal and decommissioning
costs) and residual value at the end of its useful life.

Q.7. What are the benefits of Life cycle costing ?

Ans:
a) Time based analysis: PLC costing traces cost and revenue of each product over several calendar periods. Costs
and revenues can be analyzed by time periods.
b) Overall cost analysis: PLC costing focusses on recognizing both production and non production cost like R&D
design, marketing, distribution, customer service cost etc.
c) Effective pricing decision: Since all cost are considered, effective SP can be determined for different phases of
product life cycle.
d) Better decision making : Since revenue and cost are more accurate within particular life cycle phase, better
decision can be taken.
e) Life cycle Budgeting : Life cycle budgeting (i.e. Life Cycle Costing with Target costing principles facilitates
scope for cost reduction at the design stage itself. Since costs are avoided before they are committed or locked in,
the company is benefited.