Cost Management

Study Note - 1
COST MANAGEMENT

This Study Note includes

1.1 Life Cycle Costing

1.2 Target Costing
1.3 Kaizen Costing
1.4 Value Analysis and Value Engineering
1.5 Throughput Costing
1.6 Business Process Re-engineering
1.7 Back-flush Accounting
1.8 Lean Accounting
1.9 Socio Economic Costing
1.10 Cost Control and Cost Reduction – Basics, Process, Methods and Techniques of Cost Reduction Programme

1.1 LIFE CYCLE COSTING

Meaning of Life Cycle Costing

(a) Life Cycle Costing; aims at cost ascertainment of a product, project etc. over its projected life.
(b) It is a system that tracts and accumulates the actual costs snd revenues attributable to cost object (i.e.;
product) from its inception to its abandonment.
(c) Sometimes the terms; cradle-to-grave costing and womb-to-tomb costing convey the meaning of fully
capturing all costs associated with the product from its initial to final stages.

Meaning of Product Life Cycle

(a) Product Life Cycle is a pattern of expenditure, sale level, revenue and profit over the period from new idea
generation to the deletion of product from product range.
(b) 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 product. For products like motor vehicles, this time-span may range from 5 to 7 years.
For some basic pharmaceuticals, the time-span be 7 to 10 years.
Characteristic of PLCC
(a) Involves tracing of costs and revenues of each product over several calendar periods throughout their entire
life cycle.
(b) Traces research, design and development costs and total magnitude of these costs for each individual
product and compared with product revenue.
(c) Assists report generation for costs and revenues.

Phases in Product Life Cycle:

The 4 identifiable phases in the product Life Cycle are — (a) Introduction (b) Growth (c) Maturity and (d) Decline.
A comparative analysis of these phases is given below —

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Particulars Introduction Growth Maturity Decline

Phase 1 II III IV
Sales Initial stages, hence Rise in sales levels at Rise in sales levels at Sales level off and then
Volumes low. increasing rates. decreasing rates start decreasing
Prices of High levels to cover Retention of high Prices fall closer to Gap between price
products initial costs and level prices except in cost, due to effect of and cost is further
promotional exps. certain cases. competition. reduced.
Ratio of Highest, due to effort Total expenses Ratio reaches a normal Reduced sales
promotion needed to inform remain the same, level of sales. Such promotional efforts as
expenses to potential customers, while ratio of S&D OH normal level becomes the product is no longer
sales launch products, to sales is reduced the industry standard. in demand.
distribute to customers due to increase in
etc. sales.
Competiti Negligible and Entry of a large Fierce Competition Starts disappearing
on insignificant number of due to withdrawal of
competitors. products.
Profits Nil, due to heavy initial Increase at a rapid Normal rate of profits Decline profits due to
costs pace since costs and prices price competition new
are normalized. products etc.

• in the growth stage, maintain the prices at high levels, in order to realize maximum profits.
• Price reduction will not be undertaken unless (a) the low prices will lead to market penetration, (b) the Firm
has sufficient production capacity to absorb the increased sales volume, and (c) Competitors enters the
market.

Maturity
Growth
Sales
Decline

`
Introduction

Time

Benefits of PLCC
(a) Results in earlier actions to generate revenue or to lower costs than otherwise might be considered.
(b) Ensures better decision from a more accurate and realistic assessment of revenues and costs atleast within a
particular life cycle stage.
(c) Promotes long-term rewarding.
(d) Provides an overall framework for considering total incremental costs over the life span of the product.

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Importance of Product Life Cycle Costing:

Product Life Cycle Costing is considered important due to the following reasons —
(a) Time based analysis: Life cycle costing involves tracing of costs and revenues of each product over several
calendar periods throughout their life cycle. Costs and revenues can analysed by time periods. The total
magnitude of costs for each individual product can be reported and compared with product revenues
generated in various time periods.
(b) Overall Cost Analysis: Production Costs are accounted and recognized by the routine accounting system.
However non-production costs like R&D; design; marketing; distribution; customer service etc. are less visible
on a product — by — product basis. Product Life Cycle Costing focuses on recognizing both production and
non-production costs.
(c) Pre-production costs analysis: The development period of R&D and design is long and costly. A high
percentage of total product costs maybe incurred before commercial production begin. Hence; the
Company needs accurate information on such costs for deciding whether to continue with the R&D or not.
(d) Effective Pricing Decisions: Pricing Decisions; in order to be effective; should include market considerations
on one hand and cost considerations on the other. Product Life Cycle Costing and Target Costing help
analyze both these considerations and arrive at optimal price decisions.
(e) Better Decision Making: Based on a more accurate and realistic assessment ot revenues and costs, at least
within a particular life cycle stage, better decisions can be taken.
(f) Long Run Holistic view: Product Life Cycle Costing can promote long-term rewarding in contrast to short-term
profitability rewarding. It provides an overall framework for considering total incremental costs over the entire
life span of a product, which in turn facilitates analysis of parts of the whole where cost effectiveness might
be improved.
(g) 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.
(h) Review: Life Cycle Costing provides scope for analysis of long term picture of product line profitability,
feedback on the effectiveness of life cycle planning and cost data to clarify the economic impact of
alternatives chosen in the design, engineering phase etc.

Illustration 1.
Wipro is examining the profitability and pricing policies of its Software Division. The Software Division develops
Software Packages for Engineers. It has collected data on three of its more recent packages - (a) ECE Package
for Electronics and Communication Engineers, (b) CE Package for Computer Engineers, and (c) IE Package for
Industrial Engineers.
Summary details on each package over their two year cradle to grave product lives are -

Package Selling Price Number of units sold

Year 1 Year 2

ECE ` 250 2,000 8,000

CE ` 300 2,000 3,000
IE ` 200 5,000 3,000

Assume that no inventory remains on hand at the end of year 2. Wipro is deciding which product lines to emphasize
in its software division. In the past two years, the profitability of this division has been mediocre.
Wipro is particularly concerned with the increase in R & D costs in several of its divisions. An analyst at the Software
Division pointed out that for one of its most recent packages (IE) major efforts had been made to reduce R&D
costs.

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Last week, Amit, the Software Division Manager, decides to use Life Cycle Costing in his own division. He collects
the following Life Cycle Revenue and Cost information for the packages - Amount (`)

Particulars Package ECE Package CE Package IE

Year 1 Year 2 Year 1 Year 2 Year 1 Year 2

Revenues 5,00,000 20,00,000 6,00,000 9,00,000 10,00,000 6,00,000

Costs

R&D 7,00,000 - 4,50,000 - 2,40,000 -

Design of Product 1,15,000 85,000 1,05,000 15,000 76,000 20,000

Manufacturing 25,000 2,75,000 1,10,000 1,00,000 1,65,000 43,000

Marketing 1,60,000 3,40,000 1,50,000 1,20,000 2,08,000 2,40,000

Distribution 15,000 60,000 24,000 36,000 60,000 36,000

Customer Service 50,000 3,25,000 45,000 1,05,000 2,20,000 3,88,000

Present a Product Life Cycle Income Statement for each Software Package. Which package is most profitable
and which is the least profitable? How do the three packages differ in their cost structure (the percentage of total
costs in each category)?
Answer:
Life cycle Income Statement (in ` 000s)

Particulars Package ECE Package CE Package IE

Y1 Y2 Total % Y1 Y2 Total % Y1 Y2 Total %

Revenues 500 2,000 2,500 100% 600 900 1,500 100% 1,000 600 1,600 100%

Costs

R&D 700 - 700 28% 450 - 450 30% 240 - 240 15%

Design 115 85 200 8% 105 15 120 8% 76 20 96 6%

Manufacturing 25 275 300 12% 110 100 210 14% 165 43 208 13%

Marketing 160 340 500 20% 150 120 270 18% 208 240 448 28%

Distribution 15 60 75 3% 24 36 60 4% 60 36 96 6%

Cust. Service 50 325 375 15% 45 105 150 10% 220 388 608 38%

Total Costs 1065 1,085 2150 86% 884 376 1260 84% 969 727 1696 106%

Profit 350 14% 240 16% (96) -6%

Observation: Package ECE is most profitable, while package IE is least profitable.

Illustration 2.
A2Z p.l.c supports the concept of tero technology or life cycle costing for new investment decisions covering its
engineering activities. The financial side of this philosophy is now well established and its principles extended to all
other areas of decision making. The company is to replace a number of its machines and the Production Manager
is torn between the Exe Machine, a more expensive machine with a life of 12 years, and the Wye machine with an
estimated life of 6 years. If the Wye machine is chosen it is likely that it would be replaced at the end of 6 years by
another Wye machine. The patter of maintenance and running costs differs between the two types of machine
and relevant data are shown below:

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Exe Wye
` `
Purchase price 19,000 13,000
Trade-in value/brakeup/scrap 3,000 3,000
Annual repair costs 2,000 2,600
Overhaul costs (at year 8) 4,000 (at year 4) 2,000
Estimated financing costs averaged over machine life
10%p.a  -Exe;  10% p.a.  -Wye
You are required to: recommend with supporting figures, which machine to purchase, stating any assumptions
made.
Solution:
Computation of present value of outflows and equivalent annual

` Exe machine ` WYE machine

` `
Initial cost 19,000.00 13,000.00
Less : Scrap at the end of the life (3000x0.32) 960.00 (3000X.56) 1,680.00
18,040.00 11,320.00
Present value of total annual cost (2000x6.81) 13,620.00 (2600x4.36) 11,336.00
Overhaul cost (4000X.47) 1,880.00 (2000X.68) 1,360.00
33,540.00 24,016.00
Capital recovery factor (1/6.81) 0.15 (1/4.36) 0.23
Equivalent annual cost 4,925.00 5,508.00
As the equivalent annual cost is less for exe machine, it is better to purchase the same.

Illustration 3.
Company X is forced to choose between two machines A and B. The two machines are designed differently, but
have identical capacity and do exactly the same job. Machine A costs ` 1,50,000 and will last for 3 years. It costs
`40,000 per year to run. Machine B is an ‘economy’ model costing only ` 1,00,000, but will last only for 2 years, and
costs ` 60,000 per year to run. These are real cash flows. The costs are forecasted in rupees of constant purchasing
power. Ignore tax. Opportunity cost of capital is 10%. Which machine Company X should buy?
Answer:
Compound present value of 3 years @ 10% = 2.486
P.V. of running cost of Machine A for 3 years = ` 40,000 x 2.486 = ` 99,440
Compound present value of 2 years @ 10% = 1.735
P.V. of running cost of Machine B for 2 years = ` 60,000 x 1.735 = ` 1,04,100
Statement Showing Evaluation of Machines A and B (`)
Particulars Machine A Machine B
Cost of purchase 1,50,000 1,00,000
Add: P.V. of running cost for 3 years 99,440 1,04,100
P.V. of Cash outflow 2,49,440 2,04,100
2,49,440 2,04,100
Equivalent present value of annual cash outflow 2.486 1.735
= 1,00,338 = 1,17,637

Analysis: Since the annual cash outflow of Machine B is higher, Machine A can be purchased.

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Illustration 4.
Computation of Equivalent Annual Cost and Identification of Year to Replace the Machine
A & Co. is contemplating whether to replace an existing machine or to spend money on overhauling it.
A & Co. currently pays no taxes. The replacement machine costs ` 90,000 now and requires maintenance of
` 10,000 at the end of every year for eight years. At the end of eight years it would have a salvage value of ` 20,000
and would be sold. The existing machine requires increasing amounts of maintenance each year and its salvage
value falls each year as follows:
Amount (` )

Year Maintenance Salvage

Present 0 40,000

1 10,000 25,000

2 20,000 15,000

3 30,000 10,000

4 40,000 0

The opportunity cost of capital for A & Co. is 15%.

When should the company replace the machine?
(Notes: Present value of an annuity of ` 1 per period for 8 years at interest rate of 15% : 4.4873; present value of ` 1
to be received after 8 years at interest rate of 15% : 0.3269)
Answer:
Calculation of Equivalent Annual Cost of New Machine Amount (` )
Cost of New Machine 90,000
Add: Present value of annual maintenance cost for 8 years (` 10,000 × 4.4873) 44,873
1,34,873
Less: Present value of salvage value at the end of 8th year (`20,000 × 0.3269) 6,538
Total present value of life cycle costs of new machine 1,28,335
Equivalent Annual cost = ` 1,28,335/4.4873 = ` 28,600
Calculation of Equivalent Annual cost in continuing with Existing Machine
1st Year Amount (` )
P.V. of salvage value at the beginning of 1st year 40,000
Add: P. V. of Maintenance cost (10,00/1.15) 8,696
48,696
Less: P.V. of salvage value at the end of the year (25,000/1.15) 21,739
26,957
Equivalent Annual cost at the end of 1st year (26,957 × 1.15) 31,000

2nd Year Amount (` )

P.V. of salvage value at the beginning of 2nd year 25,000
Add: P. V. of Maintenance cost (20,00/1.15) 17,391
42,391
Less: P.V. of salvage value at the end of the 2nd year (15,000/1.15) 13,043
29,348
Equivalent Annual cost at the end of 2 nd
year (29,348 × 1.15) 33,750

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3rd Year Amount (` )

P.V. of salvage value at the beginning of 3rd year 15,000
Add: P. V. of Maintenance cost (30,00/1.15) 26,087
41,087
Less: P.V. of salvage value at the end of the 3rd year (10,000/1.15) 8,696
32,391
Equivalent Annual cost at the end of 3rd year (32,391 × 1.15) 37,250

4th Year Amount (` )

P.V. of salvage value at the beginning of 4th year 10,000
Add: P. V. of Maintenance cost (40,00/1.15) 34,783
44,783
Less: P.V. of salvage value at the end of the 4th year Nil
44,783
Equivalent Annual cost at the end of 4 year th
(44,783 × 1.15) 51,500
Analysis: Since the equivalent annual cost of new machine is lesser than that of existing machine, it is suggested
to replace the existing machine with new machine. The equivalent annual cost of existing machine is higher in all
the four years as compared to new machine.

Illustration 5.

A company is considering the purchase of a machine for ` 3,50,000. It feels quite confident that it can sell the
goods produced by the machine as to yield an annual cash surplus of ` 1,00,000. There is however uncertainly as
to the machine working life. A recently published Trade Association Survey shows that members of the Association
have between them owned 250 of these machines and have found the lives of the machines vary as under:

No. of year of machine life 3 4 5 6 7 Total

No. of machines having given life 20 50 100 70 10 250
Assuming discount rate of 10% the net present value for each different machine life is follows:

Machine life 3 4 5 6 7
NPV (`) (1,01,000) (33,000) 29,000 86,000 1,37,000
You required to advice whether the company should purchase a machine or not.
Answer:
Computation of NPV of an asset considering the probability of life of machine.
Year Probability NPV Expected value
(a) ` (b) ` (a × b)
3 20/250 (1,01,000) (8,080)
4 50/250 (33,000) (6,600)
5 100/250 29,000 11,600
6 70/250 86,000 24,080
7 10/250 1,37,000 5,480
26,480
So, Assets should be purchased.

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