This is the last article following Part 1 and Part 2 of Life Cycle Costing. If you missed them, you probably want to read them now to catch up on the basic concepts of life cycle costing.
The reasoning behind life cycle costing (LCC) is that meaningful purchasing decisions need to be made only after fully considering each available option. All significant expenditure of costs and resources must be assessed for each option, from initial consideration through to disposal. The degree of sophistication of LCC will vary according to the complexity of the goods or services you are acquiring. The cost of collecting necessary data can be considerable, and where the same items are procured frequently a cost database can be useful.
The reasoning behind life cycle costing (LCC) is that meaningful purchasing decisions need to be made only after fully considering each available option. All significant expenditure of costs and resources must be assessed for each option, from initial consideration through to disposal. The degree of sophistication of LCC will vary according to the complexity of the goods or services you are acquiring. The cost of collecting necessary data can be considerable, and where the same items are procured frequently a cost database can be useful.
The following fundamental concepts are common to all applications of LCC:
Cost breakdown structure (CBS)
CBS is central to LCC analysis. It varies 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:
Cost estimating
Having produced a CBS, you then need to calculate the costs of each category. These are determined by one of the following methods:
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). You need to steadily reduce the risk allowance over time as the risks or their consequences are minimised through good risk management.
Sensitivity
The sensitivity of cost estimates to factors such as changes in volumes, usage, etc. need to be considered. We all have a tendency to be over-optimistic about key equipment/service parameters (known as optimism bias). It can arise in relation to:
You need to assess optimism bias with care, because 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. You then assess the probability of these scenarios actually happening and adjust the expected expenditure accordingly.
Discounting
Discounting is a technique used to compare costs and benefits that occur in different time periods. When comparing two or more options, you need a common base to ensure fair evaluation. As the present is the most suitable time reference, you must adjust all future costs to their present value. In other words, discounting refers to the application of a selected discount rate such that each future cost is adjusted to the 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. However, discount rates used by industry will vary considerably and care must be taken when comparing LCC analyses to ensure that a common discount rate has been 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 you need to consider inflation. However, you need to be extremely careful to avoid double counting of the effects of inflation. A vendor’s proposal may already include a provision for inflation and, unless this is noted, an additional estimate for inflation might be included.
We hope this post has given you a clearer idea of the fundamental concepts involved in life cycle costing. To learn more about this process, check out Part 1 and Part 2 on the topic.
- cost breakdown structure,
- cost estimating,
- discounting,
- inflation.
Cost breakdown structure (CBS)
CBS is central to LCC analysis. It varies 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 related to 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.
- The CBS should be compatible, through cross-indexing, with the management accounting procedures used in collecting costs. This allows costs to be fed directly into the LCC analysis.
- For programmes with sub-contractors, these costs should have separate cost categories to allow close control and monitoring.
- 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.
Cost estimating
Having produced a CBS, you then need to calculate the costs of each category. These are determined by one of the following methods:
- Known factors or rates. These are inputs to the LCC analysis, which have a known accuracy. For example, if the unit production cost (UPC) and quantity are known, then the procurement cost can be calculated.
- Cost estimating relationship (CERs). These 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. You must treat the results produced by CERs 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 data can soon become out of date.
- 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.
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). You need to steadily reduce the risk allowance over time as the risks or their consequences are minimised through good risk management.
Sensitivity
The sensitivity of cost estimates to factors such as changes in volumes, usage, etc. need to be considered. We all have a tendency to be over-optimistic about key equipment/service parameters (known as optimism bias). It can arise in relation to:
- capital costs,
- work duration,
- operating costs,
- under-delivery of benefits.
You need to assess optimism bias with care, because 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. You then assess the probability of these scenarios actually happening and adjust the expected expenditure accordingly.
Discounting
Discounting is a technique used to compare costs and benefits that occur in different time periods. When comparing two or more options, you need a common base to ensure fair evaluation. As the present is the most suitable time reference, you must adjust all future costs to their present value. In other words, discounting refers to the application of a selected discount rate such that each future cost is adjusted to the 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. However, discount rates used by industry will vary considerably and care must be taken when comparing LCC analyses to ensure that a common discount rate has been 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 you need to consider inflation. However, you need to be extremely careful to avoid double counting of the effects of inflation. A vendor’s proposal may already include a provision for inflation and, unless this is noted, an additional estimate for inflation might be included.
We hope this post has given you a clearer idea of the fundamental concepts involved in life cycle costing. To learn more about this process, check out Part 1 and Part 2 on the topic.
