Life-Cycle Product Budgeting and Costing

Learning Objective 6 Use life-cycle budgeting and costing when making pricing decisions

accumulate all costs of a product from initial R&D to final customer service for each year of the product’s life

Managers sometimes need to consider target prices and target costs over a multiple-year product life cycle. The product life cycle spans the time from initial R&D on a product to when customer service and support is no longer offered for that product. For automobile companies such as BMW, Ford, and Nissan, the typical product life cycle of a car model is 12 to 15 years from design to product introduction and sale, and, eventually, service. For pharmaceutical companies such as Pfizer, Merck, and Roche, the life cycle of a successful new medication may be 15 to 20 years. For banks such as Bank of America and Chase, a product such as a newly designed savings account with specific privileges can have a life cycle of 10 to 20 years. Personal computers have a shorter life cycle of 2 to 3 years because rapid innovations in the computing power and the speed of microprocessors that run the computers make older models obsolete fairly quickly.

In life-cycle budgeting, managers estimate the revenues and business function costs across the entire value chain from a product’s initial R&D to its final customer service and support. Life-cycle costing tracks and accumulates business function costs across the entire value chain from a product’s initial R&D to its final customer service and support. Life-cycle budgeting and life-cycle costing span several years.

Life-Cycle Budgeting and Pricing Decisions

Budgeted life-cycle costs provide useful information for strategically evaluating pricing decisions. Consider Insight, Inc., a computer software company, which is developing a new business accounting package, “General Ledger.” Assume the following budgeted amounts for General Ledger over a 6-year product life cycle:

Years 1 and 2
	Total Fixed Costs
R&D costs	$240,000
Design costs	160,000

Years 3 to 6
	Total Fixed Costs	Variable Cost per Package
Production costs	$100,000	$25
Marketing costs	70,000	24
Distribution costs	50,000	16
Customer-service costs	80,000	30

Exhibit 14-7 presents the 6-year life-cycle budget for “General Ledger” for three alternative-selling-price/sales-quantity combinations.

Table shows the 6-year life-cycle budget of revenues and costs for General Ledger of Insight, Inc. for three alternative selling-price and sales-quantity combinations.

The details of the three alternative selling-price and sales-quantity combinations such as A, B, and C are as follows:

Selling price per package
- A: $400
- B: $480
- C: $600
Sales quantity in units
- A: 5,000
- B: 4,000
- C: 2,500
Life-cycle revenues of $400 multiplied by 5,000; $480 multiplied by 4,000; and $600 multiplied by 2,500
- A: $2,000,000
- B: $1,920,000
- C: $1,500,000
Life-cycle costs
1. R and D costs
  - A: $240,000
  - B: $240,000
  - C: $240,000
2. Design costs of product or process
  - A: $160,000
  - B: $160,000
  - C: $160,000
3. Production costs of $100,000 plus $25 multiplied by 5,000; $100,000 plus $25 multiplied by 4,000; and $100,000 plus $25 multiplied by 2,500
  - A: $225,000
  - B: $200,000
  - C: $162,500
4. Marketing costs of $70,000 plus $24 multiplied by 5,000; $70,000 plus $24 multiplied by 4,000; and $70,000 plus $24 multiplied by 2,500
  - A: $190,000
  - B: $166,000
  - C: $130,000
5. Distribution costs of $50,000 plus $16 multiplied by 5,000; $50,000 plus $16 multiplied by 4,000; and $50,000 plus $16 multiplied by 2,500
  - A: $130,000
  - B: $114,000
  - C: $90,000
6. Customer-service costs of $80,000 plus $30 multiplied by 5,000; $80,000 plus $30 multiplied by 4,000; and $80,000 plus $30 multiplied by 2,500
  - A: $230,000
  - B: $200,000
  - C: $155,000
7. Total life-cycle costs
  - A: $1,175,000
  - B: $1,080,000
  - C: $937,500
Life-cycle operating income
- A: $825,000
- B: $840,000
- C: $562,500

Note:

This table does not take into consideration the time value of money when computing life-cycle revenues or life-cycles costs. Chapter 22 outlines how this important factor can be incorporated into such calculations.

Life-cycle budgeting is particularly important in certain situations, such as the following:

THE DEVELOPMENT PERIOD FOR R&D AND DESIGN IS LONG AND COSTLY. When a company incurs a large percentage of total life-cycle costs before any production begins and any revenues are received, as in the “General Ledger” example, managers need to evaluate revenues and costs over the life cycle of the product in order to decide whether to begin the costly R&D and design activities.
MANY COSTS ARE LOCKED IN AT THE R&D AND DESIGN STAGES, EVEN IF R&D AND DESIGN COSTS THEMSELVES ARE SMALL. In our “General Ledger” example, design and quality decisions about the accounting software package will affect marketing, distribution, and customer-service costs in several subsequent years. A life-cycle revenue-and-cost budget prevents Insight’s managers from overlooking these multiple-year relationships among business-function costs. Life-cycle budgeting highlights costs throughout the product’s life cycle and, in doing so, facilitates target pricing, target costing, and value engineering at the design stage before costs are locked in. The amounts presented in Exhibit 14-7 are the outcome of value engineering.

Insight’s managers decide to sell the “General Ledger” package for $480 per package because this price maximizes life-cycle operating income. They then compare actual costs to life-cycle budgets to obtain feedback and to learn about how to better estimate costs for subsequent products. Exhibit 14-7 assumes that the selling price per package is the same over the entire life cycle. For strategic reasons, however, Insight’s managers may decide to skim the market by charging higher prices to eager customers when “General Ledger” is first introduced and lowering prices later as the product matures. Managers may also decide to add new features in later years to differentiate the product to achieve higher prices and sales. The life-cycle budget will then incorporate the revenues and costs of these strategic decisions.