Life Cycle Costing

1 Fit Co specialises in the manufacture of a small range of hi-tech products for the fitness market. They are currently
considering the development of a new type of fitness monitor, which would be the first of its kind in the market. It
would take one year to develop, with sales then commencing at the beginning of the second year. The product is
expected to have a life cycle of two years, before it is replaced with a technologically superior product. The following
cost estimates have been made.
Year 1 Year 2 Year 3

l
Units manufactured and sold 100,000 200,000
Research and development costs $160,000

a
Product design costs $800,000

i
Marketing costs $1,200,000 $1,000,000 $1,750,000
Manufacturing costs:

c
Variable cost per unit $40 $42
Fixed production costs $650,000 $1,290,000

n
Distribution costs:

a
Variable cost per unit $4 $4·50
Fixed distribution costs $120,000 $120,000

n
Selling costs:

i
Variable cost per unit $3 $3·20
Fixed selling costs $180,000 $180,000
Administration costs $200,000 $900,000 $1,500,000
Note: You should ignore the time value of money.

F
Required:
(a) Calculate the life cycle cost per unit. (6 marks)

d
(b) After preparing the cost estimates above, the company realises that it has not taken into account the effect of the

e
learning curve on the production process. The variable manufacturing cost per unit above, of $40 in year 2 and

e
$42 in year 3, includes a cost for 0·5 hours of labour. The remainder of the variable manufacturing cost is not
driven by labour hours. The year 2 cost per hour for labour is $24 and the year 3 cost is $26 per hour.
Subsequently, it has now been estimated that, although the first unit is expected to take 0·5 hours, a learning
curve of 95% is expected to occur until the 100th unit has been completed.

S
Calculate the revised life cycle cost per unit, taking into account the effect of the learning curve.
Note: the value of the learning co-efficient, b, is –0·0740005.

(c) Discuss the benefits of life cycle costing.

(10 marks)

(4 marks)

(20 marks)
2 Cam Co manufactures webcams, devices which can provide live video and audio streams via personal computers. It
has recently been suffering from liquidity problems and hopes that these will be eased by the launch of its new
webcam, which has revolutionary audio sound and visual quality. The webcam is expected to have a product life cycle
of two years. Market research has already been carried out to establish a target selling price and projected lifetime
sales volumes for the product. Cost estimates have also been prepared, based on the current proposed product
specification. Cam Co uses life cycle costing to work out the target costs for its products, believing it to be more
accurate to use an average cost across the whole lifetime of a product, rather than potentially different costs for
different years. You are provided with the following relevant information for the webcam:
Projected lifetime sales volume 50,000 units
Target selling price per unit $200
Target profit margin (35% selling price) $70
Target cost per unit $130

l
Estimated lifetime cost per unit (see note below for detailed breakdown) $160

a
Note: Estimated lifetime cost per unit:

i
$ $
Manufacturing costs

c
Direct material (bought in parts) 40

n
Direct labour 26
Machine costs 21

a
Quality control costs 10
Rework costs 3

n
–––

100

i
Non-manufacturing costs
Product development costs 25
Marketing costs 35
–––

60

F
––––

Estimated lifetime cost per unit 160

––––

The average market price for a webcam is currently $150.

d
The company needs to close the cost gap of $30 between the target cost and the estimated lifetime cost. The following

e
information has been identified as relevant:

e
1. Direct material cost: all of the parts currently proposed for the webcam are bespoke parts. However, most of these
can actually be replaced with standard parts costing 55% less. However, three of the bespoke parts, which
currently account for 20% of the estimated direct material cost, cannot be replaced, although an alternative

S
supplier charging 10% less has been sourced for these parts.
2. Direct labour cost: the webcam uses 45 minutes of direct labour, which costs $34·67 per hour. The use of more
standard parts, however, will mean that whilst the first unit would still be expected to take 45 minutes, there will
now be an expected rate of learning of 90% (where ‘b’ = –0·152). This will end after the first 100 units have
been completed.
3. Rework cost: this is the average rework cost per webcam and is based on an estimate of 15% of webcams
requiring rework at a cost of $20 per rework. With the use of more standard parts, the rate of reworks will fall to
10% and the cost of each rework will fall to $18.

Required:
(a) Recalculate the estimated lifetime cost per unit for the webcam after taking into account points 1 to 3 above.
(12 marks)

(b) Explain the ‘market skimming’ (also known as ‘price skimming’) pricing strategy and discuss, as far as the
information allows, whether this strategy may be more appropriate for Cam Co than charging one price
throughout the webcam’s entire life. (8 marks)

(20 marks)
3 Shoe Co, a shoe manufacturer, has developed a new product called the ‘Smart Shoe’ for children, which has a
built-in tracking device. The shoes are expected to have a life cycle of two years, at which point Shoe Co hopes to
introduce a new type of Smart Shoe with even more advanced technology. Shoe Co plans to use life cycle costing to
work out the total production cost of the Smart Shoe and the total estimated profit for the two-year period.
Shoe Co has spent $5·6m developing the Smart Shoe. The time spent on this development meant that the company
missed out on the opportunity of earning an estimated $800,000 contribution from the sale of another product.
The company has applied for and been granted a ten-year patent for the technology, although it must be renewed
each year at a cost of $200,000. The costs of the patent application were $500,000, which included $20,000 for

l
the salary costs of Shoe Co’s lawyer, who is a permanent employee of the company and was responsible for preparing
the application.

a
The following information is also available for the next two years:

i
Year 1 Year 2

c
Sales volumes (units) 280,000 420,000
$ $

n
Selling price per unit 55 45
Material cost per unit 16 14

a
Labour cost per unit 8 7

n
Note: A unit is a pair of shoes

i
Other costs are expected to be as follows:
Year 1 Year 2
$m $m
Fixed production overheads 1·6 2·2

F
Selling and distribution costs 0·6 0·9
Environmental costs 0·1 0·15

d
Shoe Co is still negotiating with marketing companies with regard to its advertising campaign, so is uncertain as to
what the total marketing costs will be each year. However, the following information is available as regards the

e
probabilities of the range of costs which are likely to be incurred:

e
Year 1 Year 2
Expected cost Probability Expected cost Probability
($m) ($m)

S
2·2 0·2 1·8 0·3
2·6 0·5 2·1 0·4
2·9 0·3 2·3 0·3

Required:
Applying the principles of life cycle costing, calculate the total expected profit for Shoe Co for the two-year period.

(10 marks)
 Life cycle costing
1 (a) Life cycle cost per unit
$
R & D costs 160,000
Product design costs 800,000
Marketing costs 3,950,000
Fixed production costs 1,940,000
Fixed distribution costs 240,000
Fixed selling costs 360,000
Administration costs 2,600,000
Variable manufacturing costs 12,400,000
(100,000 x $40 + 200,000 x $42)
Variable distribution costs 1,300,000
(100,000 x $4 + 200,000 x $4·50)
Variable selling costs 940,000
(100,000 x $3 + 200,000 x $3·20)
–––––––––––

Total costs 24,690,000

–––––––––––

Therefore cost per unit = $24,690,000/300,000 = $82·30

(b) New life cycle cost
Total labour time for first 100 units:
y = axb
b = –0·0740005
If x = 100, then y = 0·5 x 100–0·0740005
= 0·3556 hours per unit.
Therefore total hours for 100 units = 35·56 hours
Time for 99th unit
y = 0·5 x 99–·0740005
= 0·3559 hours per unit.
Therefore total hours for 99 units = 35·23 hours.
Therefore, time for 100th unit = 35·56 hours – 35·23 hours = 0·33 hours
Total labour cost over life of product:
Year 2
100 units at 0·3556 per unit 36 hours
99,900 at 0·33 hours per unit 32,967 hours
–––––––––

33,003 hours
–––––––––

at $24 per hour $792,072

Year 3
–––––––––

200,000 at 0·33 per unit 66,000 hours

–––––––––

at $26 per hour $1,716,000

–––––––––

Total revised life cycle cost

$
Therefore total labour cost 2,508,072
Other life cycle costs from (a) 24,690,000
Less labour cost included in (a) (3,800,000)
(100,000 x 0·5 x $24) + (200,000 x 0·5 x $26)
–––––––––––

Total revised life cycle costs 23,398,072

–––––––––––

Therefore cost per unit = $23,398,072/300,000 = $77·99

(c) Benefits of life cycle costing

– The visibility of ALL costs is increased, rather than just costs relating to one period. This facilitates better
decision-making.
– Individual profitability for products is more accurate because of this. This facilitates performance appraisal and
decision-making, and means that prices can be determined with better knowledge of the true costs.
– More accurate feedback can take place when assessing whether new products are a success or a failure, since the costs
of researching, developing and designing those products are also taken into account.
2 (a) Rev i sed target cost
$ $
Manufacturing cost
Direct materi a l (wo rking 1) 21 · 60
Direct l a bour (working 2) 10 · 96
Mach i ne costs 21
Quality control costs 10
Rework costs (work i ng 3) 1 · 80
–––––

65·36
Product development cost 25
Market i ng cost 35
–––––

Non manufactur i ng costs

-

60
–––––––

Total cost 125·36

–––––––

–––––––

Working 1: Direct material cost

Parts to be r eplaced b y standard par ts = $40 x 0 8 = $32. ·

New cost of those at 45% (100% 55%) = $14·40.–

Un i q ue i rre p l aceable parts : or i g i na l cost = $ 40 x 20% = $8 .

New cost $7·20
Revised direct material cost = $14·40 + $7· 20 = $21· 60
Working 2: Direct labour
Direct l a bour cost per un i t for f i rst one hundred un i ts:
–

Y = axb
45 x 100 0 152 = 22·346654 minutes
·

Total t ime f or 100 un i ts = 2,2 34 ·665 4 minutes .

Time for the 100th unit :

Time f or 99 u nits = 45 x 99 0·152 –

= 22·380818 m i nutes .

For 99 un i ts = 2,21 5 701 minutes .

·

Therefore, time for 100th un i t = 2, 234·6654 –

2, 215·701 = 18·9644 minutes .

Time for remaining 49 , 900 units = 946,323 56 m i nutes. ·

Total l a bour t i m e for 50,000 units = 948,558 · 23 m i n utes .

Therefore total l abour cost = 948 , 558·23/60 x $ 34 · 67 = $548,108·56.
Therefore average l a bour cost per unit = $548, 108·56/50,000 = $10·96 .

Note: Some rounding is acce ptable and marks would still be giv en.
Working 3: Rework cost
Total cost = 50 , 000 x 10% x $18 = $90 , 0 00.
Cost per aver age unit = $90,000/50 , 000 = $1 · 80 .

(b) Market sk i mming

Market sk i mm i ng is a strate gy that attemp ts to exp l o i t those ar eas of the market which are re l ativel y insens i t i ve to pr i c e
c hanges . In i tia l l y , h i g h prices for the webcam would be charged in order to take ad vantage of those buyers who want to buy
i t as soon as possible, and are pre pared to pay h i gh p rices i n order to do so.
The existe nce of certain conditions i s l i kel y to make the strate gy a su i table one for Cam Co. These are as follows:
–

Where a p roduct is new and dif ferent, so that customers are prepared to pay h i gh p rices i n or der to ga i n the perce i ved
status of owning the product early. The we bcam has su perior aud i o sound and visua l qua l i ty, wh i ch does make it
d i fferent from other webcams on the market .
–

Where products have a short l i fe cyc l e th i s strate gy is more like l y to be used, because of the need to recover development
costs and make a profit qu i ckl y. The webcam does only have a two year l i fe cyc l e , wh i ch does make it rather short.
–

Where hi gh prices i n the early stages of a product ’ s l i fe cycle are expected to ge nerate hi gh in i t i a l cash i nflows. If this
were to be the case for the webcam, i t would be particu l arly useful for Cam Co because of the current li qu i d i ty prob l ems
t he co mpa ny i s suff ering Simi l a rl y, sk i mming i s use fu l to cover hi gh in i t i a l de vel opme nt costs, wh i ch have bee n incurred
.

b y Cam Co .

Where ba rr i ers to entry e x i st, whi ch dete r ot her com peti tors from entering t he m ark et; as ot herw i se, t hey w i l l be ent i ced
b y the hi gh prices being charged These mi ght include prohibitive l y h i gh investment costs, patent protection or unusual l y
.

strong brand loya l ty. It i s not c l ear from the informat i o n whether th i s i s the case for Cam Co.
–
 Where demand and se nsit i vit y of de mand to price are unknown In Cam Co’s case, market research has bee n carried
.

out to establish a price based on the customers’ perce i ved va l ue of the p roduct. The suggestion therefore is that some
i nformation is ava i l ab l e about p rice and demand , although it i s not c l ear how much i nformation is avai l a ble.

I t i s not possible to say for defin i te whether this p ric i ng strate gy wou l d be suitab l e for Cam Co, because of the lim i ted
information ava i l a b l e . However, i t does seem unusual that a h i g h tech, cut ting edge product l i ke this should be so l d at the
-

same pr i ce over i ts ent i re, sho rt life cyc l e There fore, pri ce sk i mm i ng shou l d be investi gated f u rt her, presuming that t hi s has
.

not a l ready been done b y Cam Co.

3 Total sales revenue = (280,000 x $55) + (420,000 x $45) = $15·4m + 18·9m = $34·3m.
$’000
Less costs:
Development and design costs 5,600
Patent application costs (including $20k) 500
Patent renewal costs – 2 years 400
Opportunity cost – ignore –
Total material costs [(280,000 x $16) + (420,000 x $14)] 10,360
Total labour costs [(280,000 x $8) + (420,000 x $7)] 5,180
Fixed production overheads 3,800
Marketing costs (working 1) 4,680
Selling and distribution costs 1,500
Environmental costs 250
–––––––
Total life cycle costs 32,270
–––––––
–––––––
Expected profit = $2·03m
Note
The expected profit has been calculated using life cycle costing not relevant costing. Hence, the $20,000 salary cost included in
patent costs should be included in the life cycle cost. Similarly, the opportunity cost of $800,000 is not included using life cycle
costing whereas if relevant costing was being used to decide on a particular course of action, the opportunity cost would be
included.
Working 1
Expected marketing cost in year 1: (0·2 x $2·2m) + (0·5 x $2·6m) + (0·3 x $2·9m) = $2·61m
Expected marketing cost year 2: (0·3 x $1·8m) + (0·4 x $2·1m) + (0·3 x $2·3m) = $2·07m
Total expected marketing cost = $4·68m