- 20 Marks
Question
Julmat Limited, a manufacturing company, has developed a new product that requires an initial capital investment of N5m. At the end of the product’s life, the capital equipment is expected to have a value of N3m. Julmat Limited requires an Annual Rate of Return (ARR) of 20% on its average investment on products of this type. The new product has an expected life of one year before it will be replaced by a more advanced product.
Production
The new product will be manufactured in batches of 1,000 units using a just-in-time production system.
The first batch is expected to incur a direct labour cost of N100,000, but a 75% learning curve is expected until the cumulative production equals 30 batches.
Thereafter, each batch is expected to incur the same direct labour cost as that of the 30th batch.
The expected direct materials cost for the first batch is N50,000. However, an experience curve is expected to apply to the first 10 batches produced; thereafter, no further savings in material costs per batch are expected.
Other production costs are expected to be N10,000 per batch.
Sales
Sales of the new product are expected as follows for each of the four stages of the product life cycle:
| Stage | Units Sold | Selling Price per Unit (N) |
|---|---|---|
| Introduction | 10,000 | 120 |
| Growth | 30,000 | 100 |
| Maturity | 60,000 | 80 |
| Decline | 30,000 | 50 |
Required:
a. Prepare calculations to show the total direct labour cost of the product for each of the four stages of the product life cycle. (6 Marks)
b. Assuming that there is no experience curve in relation to the product’s direct material cost, prepare a statement that shows the profitability of the new product for each of the four stages of the product life cycle individually and in total for the product’s life. (5 Marks)
c. Assuming that the direct material experience curve applies, calculate the average direct material cost per batch that must be incurred in order for the company to meet its ARR target over the life cycle of the product. (4 Marks)
d. Discuss the concept of life cycle costing and its effect on product pricing strategies at different stages of the product life cycle. Use the Julmat Limited scenario to illustrate your answer. (5 Marks)
Answer
a) Calculation of direct labour cost
Introduction stage
The learning curve applies throughout this stage
TC29 = ₦24,723 × 29 = ₦716,967
Direct labour cost for the 30th batch = ₦14,373
Therefore, the total direct labour cost for these 10 batches
= 10 × ₦14,373 = ₦143,730
Thus, the total direct labour cost for this stage of the product
life cycle is (₦346,750 + ₦143,730) = ₦490,480
Maturity stage
The learning curve effect has now ended so the direct
labour cost of these 60 batches will be:
60 batches × ₦14,373 = ₦862,380
Decline stage
The learning curve effect has now ended so the direct labour
cost of these 30 batches will be: 30 batches × ₦14,373 = ₦431,190
b)
c)
Julmat Limited requires a 20% return on its average investment.
Average investment = (N5m + N3m)/2 = N4m
Profit target is therefore 20% of N4m = N800,000
As shown in the answer to (b) above, the profit predicted without the experience curve is
N268,640 less than that required (N800,000 – N531,360).
Total production throughout the products life cycle = 130 batches,
(10+30+60+30).
Currently, the total direct material cost throughout the product life cycle
= N6.5m.
This N6.5m needs to be reduced by N268,640 to N6,231,360 which is an average direct
material cost per batch of N47.934. Therefore, average direct material cost per batch
d)
The concept of life cycle costing is that the costs and revenues of a product are accumulated
over its life cycle and its overall profitability is measured, rather than separating costs and revenues into accounting periods. In this scenario, the length of the product life cycle is 12
months but this may not coincide with the company‟s accounting year.
The statement shown in solution (b) above shows the products profitability over its life cycle.
As illustrated in the scenario to this question there are four recognized stages in the life cycle
of a product. In this scenario, it appears that Julmat Limited is using a market skimming
approach to the initial launch pricing of its product because it is starting with a high price in
the introduction stage. This is then being gradually reduced over the life cycle of the
product.
The company will not only be reducing the price of the product in order to make it harder for
competitors to enter market but also to increase the demand for its product through the growth
stage. At this time, the cost of the product will also be lower than that at the launch stage due
to the effect of learning and experience curves on its labour and material costs.
In the maturity stage, the company will reduce the selling price further to consolidate its sales
and would hope that there may be further cost savings due to economies of scale though,
these are not evident from the data in this scenario.
Finally, in the decline stage, the company will have to reduce its price to sustain sales, while
under more competition from other similar products in the market, prior to launching a new
product of its own.
- Tags: ARR, Financial Performance, Learning Curve, Life Cycle Costing
- Level: Level 2
- Topic: Costing Systems and Techniques
- Series: NOV 2018
- Uploader: Kwame Aikins