Life Cycle Costing

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Life Cycle Costing

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What is Life Cycle Costing

Why is it important

Who is involved

Principles

Process

What is Life Cycle Costing?

Life Cycle Costing (LCC) also called Whole Life Costing is a technique to establish the total cost of ownership. It is a structured approach that addresses all the elements of this cost and can be

used to produce a spend profile of the product or service over its anticipated life-span. The results of an LCC analysis can be used to assist management in the decision-making process where

there is a choice of options. The accuracy of LCC analysis diminishes as it projects further into the future, so it is most valuable as a comparative tool when long term assumptions apply to all the

options and consequently have the same impact.

This briefing provides general guidance on LCC. For guidance on the application of LCC to construction projects see Achieving Excellence Guide 7: Whole-life Costing.

For information on estimating costs and benefits of e-government projects see Measuring the expected benefits of e-government.

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. Therefore, 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.

There are 4 major benefits of LCC analysis:

● evaluation of competing options in purchasing;

● improved awareness of total costs;

● more accurate forecasting of cost profiles; and

● 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

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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. Additionally, LCC analysis allows more accurate forecasting of future expenditure to be applied to

long-term costings assessments.

Performance Trade-off Against Cost. In purchasing decisions cost is not the only factor to be considered when assessing the options (see VFM briefing). 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.

Who is involved

The investment decision maker (typically the management board) is accountable for any decisions relating to the cost of a project or programme.

The SRO is responsible for ensuring that estimates are based on whole life costs and is assisted by the project sponsor or project manager, as appropriate, together with additional professional

expertise as required.

Principles

The cost of ownership of an asset or service is incurred throughout its whole life and does not all occur at the point of acquisition. The Figure below gives an example of a spend profile showing

how the costs vary with time. In some instances the disposal cost will be negative because the item will have a resale value whilst for other procurements the disposal, termination or replacement

cost is extremely high and must be taken into account at the planning stage.

● Acquisition costs are those incurred between the decision to proceed with the procurement and the entry of the goods or services to operational use

● Operational costs are those incurred during the operational life of the asset or service

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● End life costs are those associated with the disposal, termination or replacement of the asset or service. In the case of assets, disposal cost can be negative because the asset has a

resale value.

A purchasing decision normally commits the user to over 95 per cent of the through-life costs. There is very little scope to change the cost of ownership after the item has been delivered.

The principles of LCC can be applied to both complex and simple projects though a more developed approach would be taken for say a large PFI project than a straightforward equipment

purchase.

For guidance on the application of Life Cycle Costing and cost management to property and construction projects, see Achieving Excellence Guide 7: Whole-life Costing

The Process

LCC involves identifying the individual costs relating to the procurement of the product or service. These can be either “one-off” or “recurring” costs. It is important to appreciate the difference

between these cost groupings because one-off costs are sunk once the acquisition is made whereas recurring costs are time dependent and continue to be incurred throughout the life of the

product or service. Furthermore, recurring costs can increase with time for example through increased maintenance costs as equipment ages.

The types of costs incurred will vary according to the goods or services being acquired, some examples are given below.

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

Examples of recurring costs include:

● retraining;

● operating costs;

● service charges;

● contract and supplier management costs;

● changing volumes;

● cost of changes;

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● downtime/non-availability;

● maintenance and repair; and

● transportation and handling.

The Methodology of LCC

LCC is based on the premise that to arrive at meaningful purchasing decisions full account must be taken of each available option. All significant expenditure of resources which is likely to arise as

a result of any decision must be addressed. Explicit consideration must be given to all relevant costs for each of the options from initial consideration through to disposal.

The degree sophistication of LCC will vary according to the complexity of the gods or services to be procured. The cost of collecting necessary data can be considerable, and where the same

items are procured frequently a cost database can be developed.

The following fundamental concepts are common to all applications of LCC:

● cost breakdown structure;

● cost estimating;

● discounting; and

● inflation.

Cost breakdown structure (CBS)

CBS is central to LCC analysis. It will vary in complexity depending on the purchasing decision. Its aim is to identify all the relevant cost elements and it must have well defined boundaries to avoid

omission or duplication. Whatever the complexity any CBS should have the following basic characteristics:

● it must include all cost elements that are relevant to the option under consideration including internal costs;

● each cost element must be well defined so that all involved have a clear understanding of what is to be included in that element;

● each cost element should be identifiable with a significant level of activity or major item of equipment or software;

● the cost breakdown should be structured in such a way as to allow analysis of specific areas. For example, the purchaser might need to compare spares costs for each option; these costs

should therefore be identified within the structure;

● the CBS should be compatible, through cross indexing, with the management accounting procedures used in collecting costs. This will allow costs to be fed directly to the LCC analysis;

● for programmes with subcontractors, these costs should have separate cost categories to allow close control and monitoring; and

● the CBS should be designed to allow different levels of data within various cost categories. For example, the analyst may wish to examine in considerable detail the operator manpower

cost whilst only roughly estimating the maintenance manpower contribution. The CBS should be sufficiently flexible to allow cost allocation both horizontally and vertically.

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Cost Estimating

Having produced a CBS, it is necessary to calculate the costs of each category. These are determined by one of the following methods:

● known factors or rates: are inputs to the LCC analysis which have a known accuracy. For example, if the Unit Production Cost and quantity are known, then the Procurement Cost can be

calculated. Equally, if costs of different grades of staff and the numbers employed delivering the service are known, the staff cost of service delivery can be calculated;

● cost estimating relationships (CERs): are derived from historical or empirical data. For example, if experience had shown that for similar items the cost of Initial Spares was 20 per cent of

the UPC, this could be used as a CER for the new purchase. CERs can become very complex but, in general, the simpler the relationship the more effective the CER. The results

produced by CERs must be treated with caution as incorrect relationships can lead to large LCC errors. Sources can include experience of similar procurements in-house and in other

organisations. Care should be taken with historical data, particularly in rapidly changing industries such as IT where can soon become out of date; and.

● expert opinion: although open to debate, it is often the only method available when real data is unobtainable. When expert opinion is used in an LCC analysis it should include the

assumptions and rationale that support the opinion.

Discounting

Discounting is a technique used to compare costs and benefits that occur in different time periods. It is a separate concept from inflation, and is based on the principle that, generally, people prefer

to receive goods and services now rather than later. This is known as ‘time preference’. This guidance does not cover the topic in great detail as it is a procedure common to many cost appraisal

methods and well understood by purchasing officers. The subject is fully explained in “The Green Book: Appraisal and Evaluation in Central Government 2003".

When comparing two or more options, a common base is necessary to ensure fair evaluation. As the present is the most suitable time reference, all future costs must be adjusted to their present

value. Discounting refers to the application of a selected discount rate such that each future cost is adjusted to present time, i.e. the time when the decision is made. Discounting reduces the

impact of downstream savings and as such acts as a disincentive to improving the reliability of the product.

The procedure for discounting is straightforward and discount rates for government purchases are published in the Green Book. Discount rates used by industry will vary considerably and care

must be taken when comparing LCC analyses which are commercially prepared to ensure a common discount rate is used.

Inflation

It is important not to confuse discounting and inflation: the Discount Rate is not the inflation rate but is the investment “premium” over and above inflation. Provided inflation for all costs is

approximately equal, it is normal practice to exclude inflation effects when undertaking LCC analysis.

However, if the analysis is estimating the costs of two very different commodities with differing inflation rates, for example oil price and man-hour rates, then inflation would have to be considered.

However, one should be extremely careful to avoid double counting of the effects of inflation. For example, a vendor’s proposal may already include a provision for inflation and, unless this is

noted, there is a strong possibility that an additional estimate for inflation might be included.

Other issues

Risk assessment

Cost estimates are made up of the base estimate (the estimated cost without any risk allowance built in) and a risk allowance (the estimated consequential cost if the key risks materialise). The

risk allowance should be steadily reduced over time as the risks or their consequences are minimised through good risk management.

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Sensitivity

The sensitivity of cost estimates to factors such as changes in volumes, usage etc need to be considered

Optimism bias

Optimism bias is the demonstrated systematic tendency to be over-optimistic about key project parameters. In can arise in relation to:

● Capital costs;

● Works duration;

● Operating costs; and

● Under delivery of benefits.

Optimism bias needs to be assessed with care, because experience has shown that undue optimism about benefits that can be achieved in relation to risk will have a significant impact on costs. A

recommended approach is to consider best and worst case scenarios, where optimism and pessimism can be balanced out. The probability of these scenarios actually happening is assessed and

the expected expenditure adjusted accordingly. For more on optimism bias see the Green Book.

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