Life Cycle Costing By Rajat Shuvro Bakshi Formerly Professor of Strategic Management and International Business Indian Institute of Foreign Trade, Management Development Institute, International Management Institute

Genesis At the beginning, it was used to estimate the profitability of industrial large-scale projects Tool used to anlyse the profitability of products Assumption –Product results in costs and revenues over its entire life cycle.

Why is it important? The visible costs of any purchase represent only a small proportion of the total cost of ownership. In many departments, the responsibility for acquisition cost and subsequent support funding are held by different areas and, consequently, there is little or no incentive to apply the principles of LCC to purchasing policy. Hence, the application of LCC does have a management implication because purchasing units are unlikely to apply the rigours of LCC analysis unless they see the benefit resulting from their efforts.

LCC analysis There are 4 major benefits of LCC analysis: 1. evaluation of competing options in purchasing; 2. improved awareness of total costs; 3. more accurate forecasting of cost profiles; and 4. performance trade-off against cost.

Option Evaluation LCC techniques allow evaluation of competing proposals on the basis of through life costs. LCC analysis is relevant to most service contracts and equipment purchasing decisions.

Improved Awareness Application of LCC techniques provides management with an improved awareness of the factors that drive cost and the resources required by the purchase. It is important that the cost drivers are identified so that most management effort is applied to the most cost effective areas of the purchase. Additionally, awareness of the cost drivers will also highlight areas in existing items which would benefit from management involvement.

Improved Forecasting The application of LCC techniques allows the full cost associated with a procurement to be estimated more accurately. It leads to improved decision making at all levels, for example major investment decisions, or the establishment of cost effective support policies. LCC analysis allows more accurate forecasting of future expenditure to be applied to long-term costing assessments.

Performance Trade-off Against Cost In purchasing decisions cost is not the only factor to be considered when assessing the options. There are other factors such as the overall fit against the requirement and the quality of the goods and the levels of service to be provided. LCC analysis allows for a cost trade-off to be made against the varying attributes of the purchasing options.

The Methodology of LCC The following fundamental concepts are common to all applications of LCC: cost breakdown structure; cost estimating; discounting; and inflation

The Process Examples of one-off costs include: procurement; implementation and acceptance; initial training; documentation; facilities; transition from incumbent supplier(s); changes to business processes. withdrawal from service and disposal

The Process (continued) Examples of recurring costs include: retraining; operating costs; service charges; contract and supplier management costs; changing volumes; cost of changes; downtime/non-availability; maintenance and repair; and transportation and handling.

Product Life-Cycle concept market researchproduct launchwarranty product designgrowthmaintenance, repairs product developmentmaturationdisposal planning of mang. processes and sales promotions decline Time Research Dev. & Engg. cycle Manufacturing & Sales cycle Post-sale Service & Disposal cycle source: Kremin-Buch (2004), p.144

Research Development & Engineering (RD&E) cycle Pre-production costs Technology driven spendings (e.g. R&D) Market driven spendings (e.g. Mkt. research) Other spendings Pre-production revenues (e.g. subsidies for R&D)

Manufacturing & Sales cycle Market driven costs Lunch and Re-launch spendings Current costs Market driven revenues Promotion revenues Current revenues

Post-Sale Service & Disposal cycle Follow-up costs Maintenance & Repair costs Disposal costs Others e.g. cost of spare parts Follow-up revenues Maintenance & Repair revenues Liquidation revenues

Issue & Consequence ISSUE Increase of pre-production and follow-up costs Pre-production and follow-up costs treated as period costs CONSEQUENCE –Allocation of overhead costs to products which do not cause these Wrong net income of a given period

Characteristics of Product Life-cycle Costing A systematic consideration of product costs during the products lifetime “Womb to Tomb” or “Cradle to Grave” Planning tool Implications for costing after product’s launch Main objectives Minimise Life cycle costs Current profitability calculations during entire life cycle Approaches Focus on capital budgeting Focus on contribution analysis

Approaches of Product Life-cycle Costing Focus on Capital Budgeting Capital budgeting: collection of tools that planners use to evaluate the desirability of acquiring long-term assets Calculation basis: –cash inflows & outflows (instead of revenues & costs) »primary calculation basis »no focus on periods Matching of capital budgeting & cost accounting »information needed for planning & controlling is provided by both »separation useless