Life cycle costing, the costs incurred during manufacturing

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Life-cycle costag estimates and accumulates costs over a product's entire life cycle in order to determine whether the profits earned during the manufacturing phase will cover

the costs incurred duing the pre- and post-manufacturing stages. Identifying the costs

incurred during the diferent stages of a product's life cycle provides an insight into

understanding and managing the total costs incurred throughout its life cycle. In particular,

life-cycle costing helps management to understand the cost consequences of developing

and making a product and to identify areas in which cost reduction eforts are likely to be

most efective.

Figure illustrates a typical pattern of cost commitment and cost incurrence during

the three stages of a product's life cycle - the planning and design stage, the manufacturing

stage and the service and abandonment stage. Committed or locked-m costs are those

costs that have not been incurred but that will be incurred in the future on the basis of

decisions that have already been made. It is difficult to signiicantly alter costs ater they

have been committed. For example, the product design speciications determine a product's

material and labour inputs and the production process. At this stage costs become

committed and broadly determine the future costs that will be incurred during the

manufacturing stage.

An understanding of life-cycle costs and how they are committed and incurred at diferent

stages throughout a product's life cycle led to the emergence of target costSeg, a technique

that focuses on managing costs during a product's planning and design phase.

Target costing:

Stage 1: Determine the target pice which customers will be prepared to pay for

the product.

Stage 2: Deduct a target proit margin rom the target pice to determine the target cost

Stage 3: Estimate the actual cost of the product.

Stage 4: If estimated actual cost exceeds the target cost investigate ways of diving

down the actual cost to the target cost.

Activity-based management

The early adopters of acivity-based costing (ABC) used it to produce moe accurate product (or service) costs but it soon became appaent to the users that it could be extended beyond puely product costing to a range of cost management applications. The terms actiiviitty-ased mmannageinnieimt (ABM) or aictnvBty-Ibaised cost nmaimageiimeiiit (ABCM) ae used to descibe the cost management applicaions of ABC.

distinguishing feature of ABM reporting is that it oten reports information on aciviies

that cross departmental boundaies. For example, diferent producion departments and the

distribuion department might undertake customer processing acivities. They may resolve

customer problems by expediting late deliveries. The inance department may assess

customer credit worthiness and the remaining customer processing acivities might be

undertaken by the customer service department. Therefore the total cost of the customer

processing activity could be considerably in excess of the costs that are assigned to the

customer service department. However, to simplify the pesentaion it is assumed in

Exhibit 15.1 that the departmental and acivity costs are idenical but if the cost of the

customer order processing acivity was found to be, say, three times the amount assigned to

the customer service department, this would be important informaion because it may

change the way in which the managers view the acivity. For example, the managers may

give more attenion to educing the costs of the customer processing acivity.

It is apparent rom an examination of Exhibit 15.1 that the ABM approach provides more meaningful information. It gives more visibility to the cost of undertaking the acivities that make up the organizaion and may raise issues for management acion that are not highlighted by the traditional analysis. For example, why is £90000 spent on resolving customer problems? Attention-diecting informaion such as this is important for managing the cost of the aciviies.

Johnson (1990) suggests that knowing costs by activiies is a catalyst that eventually tiggers the acion necessary to become compeiive. Consider a situation where sales¬ persons, as a result of costing activiies, are informed that it costs £50 to process a customer's order. They theefore become awae that it is quesionable to pursue orders with a low sales value. By eliminating many small orders, and concentrating on larger value orders, the demand for customer-processing activiies should decease, and future spend¬ ing on this acivity should be reduced.


Pior to the introducion of ABM most organizaions have been unaware of the cost of

undertaking the activiies that make up the organizaion. Knowing the cost of acivities

enables those aciviies with the highest cost to be highlighted so that they can be

pioitized for detailed studies to ascertain whether they can be eliminated or performed

more efficiently. To identify and pioitize the potential for cost reduction many organiza¬

ions have fouia* it useful to classify aciviies as either value added or non-value added.

Deiniions of what constitutes value added and non-value added acivities vary. A

common deinition is that a valune added activity is an activity that customers perceive

as adding usefulness to the product or service they purchase. For example, painting a car

would be a value added acivity in an organizaion that manufactures cars. Other

deinitions are an activity that is being performed as eficiently as possible or an activity

that supports the primary objective of producing outputs.

In contrast, a aoM-vakiie added activity is an acivity where there is an opportunity for

cost reducion without reducing the product's service potential to the customer. Examples

of non-value added aciviies include inspecting, storing and moving raw mateials. The

cost of these aciviies can be reduced without reducing the value of the products to the

customers. Non-value added aciviies are essentially those activiies that customers should

not be expected to pay for. Reporting the cost of non-value added aciviies draws

management's attention to the vast amount of waste that has been tolerated by the

organization. This should pioitize those aciviies with the greatest potential for cost

reduction by eliminating or carrying them out more efectively, such as reducing mateial

movements, improving production lows and taking acions to reduce stock levels. Taking

acion to reduce or eliminate non-value added aciviies is given top pioity because by

doing so the organizaion permanently reduces the cost it incurs without reducing the value

of the product to the customer.

Kaplan and Cooper (1998) citicize the classiication of aciviies by simplisic value

added and non-value added categoies. They point out, that apart rom the extreme

examples similar to the ones illustrated above, people cannot consistently deine what

constitutes a value added or non-value added acivity. To reinforce this point they discuss

whether the activity of setting up a machine is value added or non-value added. One view

is that customers do not perceive performing set-ups as adding usefulness to products and

the acivity is non-value added. However, without set-ups a plant can only produce single

products. If customers value customized or diverse products, changing machine settings

rom the ability to produce diferent product vaieies creates value for customers. Kaplan

and Cooper also point out the demoivating impact when employees are informed that they

are performing non-value added acivities.

To overcome the above problems Kaplan and Cooper advocate that instead of using a

value added/non-value added classiication the following simple ive point scale should be

used to summaize an ABC project team's initial judgement about the current eiciency of

an acivity:

1. highly eicient, with little (less than 5%) apparent opportunity for improvement;

2. modestly eicient, some (5-15%) opportunity for improvement;

3. average eiciency, good opportuniies (15-25%) for improvement;

4. ineicient, major opportunities (25-50%) for improvement;

5. highly ineicient, perhaps should not be done at all; 50-100% opportunity for


By identifying the cost of acivities that make up their organizaion and classifying them

into the above ive categories, opportuniies for cost reduction can be pioitized. Cost

reducion can be achieved by either eliminating the activiies, performing them more


eiciently with fewer organizaional resources or redesigning them so that they are performed in an enirely diferent and more cost eicient way. We shall consider how acivities can be redesigned later in the chapter.

Our discussion so far has related to the application of ABM during the manufacturing

or service phase of a product's life cycle. However, some organizaions have used their

acivity-based costing systems to influence future costs at the design stage within the target

costing process. For example, the Tektronix Portable Instruments Division assigned

mateial support expenses using a single cost diver-number of part numbers. The

company wanted to encourage design engineers to focus their attention on reducing the

number of part numbers, parts and vendors in future generaions of products. Product

timeliness was seen as a citical success factor and this was facilitated by designs which

simpliied parts procurement and production processes. The cost system moivated

engineers to design simpler products requiring less development time because they had

fewer parts and part numbers. The cost system designers knew that most of the mateial

support expenses were not incurred in direct proporion to the single cost diver chosen,

but the simpliied and imprecise cost system focused attention on factors deemed to be

most citical to the division's future success.

A survey of acivity-based costing applications by Innes and Mitchell (1995a) indicated

that many organizations use cost diver rates as a measure of cost eiciency and

performance for the activity concerned. The cost driver rate is computed by dividing

the activity costs by the cost diver volume. For example, if the cost of processing 10000

purchase orders is £100000, the cost per purchasing order is £10. Assume now that

improvements in procedures in the purchasing activity enable costs to be reduced to

£80000. If the same number of orders can be processed with fewer resources the cost of

processing an order will be reduced to £8. Reporting and focusing on cost diver rates can

thus be used to moivate managers to reduce the cost of performing acivities.

There is a danger, however, that cost diver rates can encourage dysfunctional

behaviour. An improvement in the cost diver rate can be achieved by splitting some

purchase orders and increasing the orders processed to, say, 12 000. Assuming that the cost

of the acivity remains unchanged at £100000 the cost per purchasing order will be

reduced rom £10 to £8.33 if all costs are ixed in the short term. The overall efect is that

the workload will be increased and, in the long term, this could result in an increase in

costs. Care should therefore be taken to avoid these dysfunctional consequences by using

cost diver rates as feedback informaion to guide employees in improving the eiciency of

performing activiies. If the measures are interpreted in a recriminatory or threatening

manner, there is a danger that they will lead to dysfunctional behaviour.

Business process re-engineering

BtmsDimess process jre-engimeernmg involves examining business processes and making substanial changes to how the organizaion currently operates. It involves the redesign of how work is done through aciviies. A business process consists of a collecion of activiies that are linked together in a co-ordinated manner to achieve a speciic objective. For example, mateial handling might be classed as a business process consisting of separate aciviies relating to scheduling production, storing mateials, processing purchase orders, inspecting mateials and paying suppliers.

The aim of business process re-engineering is to improve the key business processes in

an organization by focusing on simpliicaion, cost reduction, improved quality and

enhanced customer satisfaction. Consider the mateials handling process outlined in the

above paragraph. The process might be re-engineered by sending the production schedule


direct to nominated suppliers and entering into contractual agreements to deliver the mateials in accordance with the production schedule and also guaranteeing their quality by inspecting them pior to delivery. The end result might be the elimination, or a permanent reduction, of the storing, purchasing and inspection aciviies. These aciviies are non-value added activiies since they represent an opportunity for cost reduction without reducing the products' service potentials to customers.

A distinguishing feature of business process re-engineering is that it involves radical

and dramaic changes in processes by abandoning current practices and reinventing

completely new methods of performing business processes. The focus is on major changes

rather than marginal improvements. A further example of business process e-engineering

is moving rom a traditional functional plant layout to a just-in-time cellular product layout

and adopting a just-in-time philosophy. Adopting a just-in-time (JIT) system and

philosophy has important implicaions for cost management and performance reporting.

It is therefore important that you understand the nature of such systems and how they difer

rom tradiional systems, but rather than deviating at this point rom our discussion of cost

management the descipion of a JIT system will be deferred unil the end of the chapter.

Cost of quality

To compete successfully in today's global competiive environment companies are

becoming 'customer-diven' and making customer saisfacion an overiding pioity.

Customers are demanding ever-improving levels of service regarding cost, quality,

reliability, delivery and the choice of innovaive new products. Quality has become one

of the key compeitive variables and this has created the need for management accountants

to become more involved in the provision of informaion relating to the quality of products

and services and activiies that produce them. In the UK quality related costs have been

reported to range rom 5 to 15% of total company sales revenue (Plunkett et ai, 1985).

Eliminating infeior quality can therefore result in substanial savings and higher revenues.

Total qanaMiry maaiinmgeinmeioit (TQM), a term used to descibe a situaion where all

business functions are involved in a process of continuous quality improvement, has been

adopted by many companies. TQM has broadened, rom its early concentration on the

staisical monitoring of manufacturing processes, to a customer-oiented process of

continuous improvement that focuses on delivering products or services of consistent

high quality in a timely fashion. In the 1980s most European and Ameican companies

considered quality to be an addiional cost of manufacturing, but by the end of the decade

they began to realize that quality saved money. The philosophy of emphasizing producion

volume over quality resulted in high levels of stocks at each production stage in order to

protect against shortages caused by infeior quality at previous stages and excessive

expenditure on inspecion, rework, scrap and warranty repairs. Companies discovered that

it was cheaper to produce the items correctly the irst time rather than wasting resources by

making substandard items that have to be detected, eworked, scrapped or returned by


Management accounting systems can help organizaions achieve their quality goals by

providing a vaiety of reports and measures that moivate and evaluate manageial eforts

to improve quality. These will include inancial and non-inancial measures. Many

companies are currently not aware of how much they are spending on quality. Managers

need to know the costs of quality and how they are changing over time. A cost of quality

report should be prepared to indicate the total cost to the organizaion of producing

products or services that do not conform with quality requirements. Four categoies of

costs should be reported.


1. FreveimtEOE costs are the costs incured in preventing the producion of products that

do not conform to speciicaion. They include the costs of prevenive maintenance,

quality planning and training and the extra costs of acquiring higher quality raw


2. Appraisal! costs are the costs incurred to ensure that mateials and products meet

quality conformance standards. They include the costs of inspecting purchased parts,

work in process and inished goods, quality audits and ield tests.

3. Innemmall failure costs are the costs associated with mateials and products that fail to

meet quality standards. They include costs incurred before the product is despatched to

the customer, such as the costs of scrap, repair, downtime and work stoppages caused

by defects.

4. Extenal faioire costs are the costs incurred when products and services fail to

conform to requirements or saisfy customer needs ater they have been delivered.

They include the costs of handling customer complaints, warranty replacement, repairs

of returned products and the costs aising rom a damaged company reputation. Costs

within this category can have a dramaic impact on future sales.

Exhibit 15.2 presents a typical cost of quality report. Note that some of the items in the

report will have to be estimated. For example, included in the external failure costs

category is the forgone contibuion rom lost sales aising rom poor quality. This cost is

extremely dificult to estimate. Nevertheless, the lost contibution can be substantial and it

is preferable to include an estimate rather than omit it rom the report. By expressing each

category of costs as a percentage of sales revenues compaisons can be made with previous

peiods, other organizaions and divisions within the same group. Such compaisons can

highlight problem areas. For example, compaisons of external failure costs with other

companies can provide an indicaion of the current level of customer saisfaction.

The cost of quality report can be used as an attention-directing device to make the top management of a company aware of how much is being spent on quality-related costs. The report can also draw management's attenion to the possibility of reducing total quality costs by a wiser allocaion of costs among the four quality categoies. For example, by spending more on the prevention costs, the amount of spending in the internal and external failure categoies can be substanially reduced, and therefore total spending can be lowered. Also, by designing quality into the products and processes, appraisal costs can be reduced, since far less inspecion is required.

Prevenion and appraisal costs are sometimes referred to as the costs of qanaMty

coeformamice or compMamice and internal and external failure costs are also known as the

costs of Eoe-coefonmainice or nnoim-coinnipMaece. Costs of compliance are incurred with the

intenion of eliminating the costs of failure. They are discreionary in the sense that they do

not have to be incurred whereas costs of non-compliance are the result of production

imperfections and can only be reduced by increasing compliance expenditure. The optimal

investment in compliance costs is when total costs of quality reach a minimum. This can

occur when 100 per cent quality compliance has not been achieved. It is virtually

impossible to measure accurately all quality costs (particularly the lost contibuion

rom forgone sales) and determine the optimal investment in conformance costs. However, some people argue that a failure to achieve 100 per cent quality compliance is non-optimal and that a zero-defects policy is optimal. With a zero-defects policy the focus is on continuous improvement with the ultimate aim of achieving zero-defects and eliminating all internal and external failure costs.

A zero-defects policy does not use percentages as the unit of measurement because a

small percentage defect rate can result in a large number of defects. For example, a 1%

defect rate rom an output of 1 million units results in 10000 defective units. To overcome



Cost of quality


% of sales

Prevention costs

Quality training

Supplier reviews

Quality engineeing

Preventive maintenance

Appraisal costs

Inspection of mateials received

Inspection of WIP and completed units Testing equipment

Quality audits

Internal failure costs



Downtime due to quality problems Retesting

External failure costs



Warranty repairs

Handling customer complaints

Foregone contibuion rom lost sales

(£000s) (£50 million)





2200 4.4





2600 5.2




400 2800 5.6






3 000

7300 14.6

14900 29.8

this problem the attainment of a zero-defects goal is measured in parts per million (PPM)

so that seemingly small numbers can be transferred into large numbers. Thus, instead of

reporting a 1 % defect rate, a measure of 10 000 PPM is more likely to create pressure for

action and highlight the trend in defect rates. Cost of quality reports provide a useful

summary of quality efforts and progress to top management, but at lower management

levels non-inancial quality measures provide more timely and appropriate target measures

for quality improvement. These measures will be discussed in the next chapter.