Reporters: Malabaguio, Reymark Merca, Rossel

nej26

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.

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 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 . 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 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 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.

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; 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 goods 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.

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 organizations. 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.

 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.

 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 manhour 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 vendors 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 materialize). The risk allowance should be steadily reduced over time as the risks or their consequences are minimized through good risk management.

 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.

Reporters: Malabaguio, Reymark Merca, Rossel

Description
Doing a life-cycle cost analysis (LCC) gives

the total cost of your PV system - including all expenses incurred over the life of the system. There are two reasons to do an LCC analysis: 1) to compare different power options, and 2) to determine the most costeffective system designs.

 An LCC analysis allows the designer to study

the effect of using different components with different reliabilities and lifetimes. For instance, a less expensive battery might be expected to last 4 years while a more expensive battery might last 7 years. Which battery is the best buy? This type of question can be answered with an LCC analysis.

 The LCC analysis consists of finding the present worth of any expense expected to occur over the reasonable life of the system. To be included in the LCC analysis, any item must be assigned a cost, even though there are considerations to which a monetary value is not easily attached. For instance,

the cost of a gallon of diesel fuel may be known; the cost of storing the fuel at the site may be estimated with reasonable confidence; but, the cost of pollution caused by the generator may require an educated guess. Also, the competing power systems will differ in performance and reliability.

 To obtain a good comparison, the reliability

and performance must be the same. This can be done by upgrading the design of the least reliable system to match the power availability of the best. In some cases, you may have to include the cost of redundant components to make the reliability of the two systems equal.

LCC Calculation
The life-cycle cost of a project can be calculated using the formula:

LCC = C + Mpw + E pw + R pw - S pw.

where the pw subscript indicates the present worth of each factor.

LCC = C + Mpw + E pw + R pw - S pw.

The capital cost (C) of a project includes the initial

capital expense for equipment, the system design, engineering, and installation. This cost is always considered as a single payment occurring in the initial year of the project, regardless of how the project is financed. Maintenance (M) is the sum of all yearly scheduled operation and maintenance (O&M) costs. Fuel or equipment replacement costs are not included. O&M costs include such items as an operator's salary, inspections, insurance, property tax, and all scheduled maintenance.

LCC = C + Mpw + E pw + R pw - S pw.

The energy cost (E) of a system is the sum of the yearly

fuel cost. Energy cost is calculated separately from operation and maintenance costs, so that differential fuel inflation rates may be used. Replacement cost (R) is the sum of all repair and equipment replacement cost anticipated over the life of the system. The replacement of a battery is a good example of such a cost that may occur once or twice during the life of a PV system. Normally, these costs occur in specific years and the entire cost is included in those years.

LCC = C + Mpw + E pw + R pw - S pw.

The salvage value (S) of a system is its net

worth in the final year of the life-cycle period. It is common practice to assign a salvage value of 20 percent of original cost for mechanical equipment that can be moved. This rate can be modified depending on other factors such as obsolescence and condition of equipment.

 Future costs must be discounted because of the time value of money. One dollar received today is worth more than the promise of $1 next year, because the $1 today can be invested and earn interest. Future sums of money must also be discounted because of the inherent risk of future events not occurring as planned. Several factors should be considered when the period for an LCC analysis is chosen.

sample
First is the life span of the equipment. PV modules should operate for 20 years or more without failure. To analyze a PV system over a 5-year period would not give due credit to its durability and reliability. Twenty years is the normal period chosen to evaluate PV projects. However, most engine generators won't last 20 years so replacement costs for this option must be factored into the calculation if a comparison is to be made.

 The discount rate selected for an LCC analysis has a large effect on the final results. It should reflect the potential earnings rate of the system owner. Whether the owner is a national government, small village, or an individual, money spent on a project could have been invested elsewhere and earned a certain rate of return. The nominal investment rate, however, is not an investor's real rate of return on money invested.

 Inflation, the tendency of prices to rise over

time, will make future earnings worth less. Thus, inflation must be subtracted from an investor's nominal rate of return to get the net discount rate (or real opportunity cost of capital). For example, if the nominal investment rate was 7 percent, and general inflation was assumed to be 2 percent over the LCC period, the net discount rate that should be used would be 5 percent.

 Different discount rates can be used for different commodities. For instance, fuel prices may be expected to rise faster than general inflation. In this case, a lower discount rate would be used when dealing with future fuel costs. In the example above the net discount rate was assumed

to be 5 percent. If the cost of diesel fuel was expected to rise 1 percent faster than the general inflation rate, then a discount rate of 4 percent would be used for calculating the present worth of future fuel costs.

 You have to make an estimate about future rates, realizing that an error in your guess can have a large affect on the LCC analysis results. If you use a discount rate that is too low, the future costs will be exaggerated; using a high discount rate does

just the opposite, emphasizing initial costs over future costs. You may want to perform an LCC analysis with "high, low and medium" estimates on future rates to put bounds on the life-cycle cost of alternative systems.

Formulas
1. The formula for the single present

worth (P) of a future sum of money (F) in a given year (N) at a given discount rate (I) is P = F/(1 + I)N.

 2. The formula for the uniform present

worth (P) of an annual sum (A) received over a period of years (N) at a given discount rate (I) is P = A[1 - (1 + I)-N]/I.

 As mentioned, target costing places

great emphasis on controlling costs by good product design and production planning, but those up-front activities also cause costs. There might be other costs incurred after a product is sold such as warranty costs and plant decommissioning.

 When seeking to make a profit on a

product it is essential that the total revenue arising from the product exceeds total costs, whether these costs are incurred before, during or after the product is produced. This is the concept of life cycle costing, and it is important to realize that target costs can be driven down by attacking any of the costs that relate to any part of a products life.

The cost phases of a product can be identified as:

Phase Examples of types of cost Design Research, development, design and tooling Manufacture Material, labor, overheads, machine set up, inventory, training, production machine maintenance and depreciation Operation Distribution, advertising and warranty claims End of life Environmental clean-up, disposal and decommissioning

There are four principal lessons to be learned from lifecycle costing:

All costs should be taken into account when working out the cost of a unit and its profitability. Costs are committed and incurred at very different times. A committed cost is a cost that will be incurred in the future because of decisions that have already been made. Costs are incurred only when a resource is used.

 Attention to all costs will help to reduce the cost per unit and will help an organization achieve its target cost. Many costs will be linked. For example, more attention to design can reduce manufacturing and warranty costs. More attention to training can reduce machine maintenance costs. More attention to waste disposal during manufacturing can reduce end-of life costs.

Typically the following pattern of costs committed and costs incurred is observed:

 The diagram shows that by the end of the design phase

approximately 80% of costs are committed. For example, the design will largely dictate material, labor and machine costs. The company can try to haggle with suppliers over the cost of components but if, for example, the design specifies 10 units of a certain component, negotiating with suppliers is to have only a small overall effect on costs. A bigger cost decrease would be obtained if the design had specified only eight units of the component. The design phase locks the company in to most future costs and it this phase which gives the company its greatest opportunities to reduce those costs.

A numerical example of target and life cycle costing:

A company is planning a new product. Market research information suggests that the product should sell 10,000 units at P21.00/unit. The company seeks to make a mark-up of 40% product cost. It is estimated that the lifetime costs of the product will be as follows: 1.Design and development costs P50,000 2. Manufacturing costs P10/unit 3.End of life costs P20,000 The company estimates that if it were to spend an additional P15,000 on design, manufacturing costs/ unit could be reduced.

 Required

(a) What is the target cost of the product? (b) What is the original lifecycle cost per unit and is the product worth making on that basis? (c) If the additional amount were spent on design, what is the maximum manufacturing cost per unit that could be tolerated if the company is to earn its required mark-up?

Solution:
The target cost of the product can be calculated as

follows: (a) Cost + Mark-up = Selling price 100% +40% = 140% P15+ P6 = P21

(b) The original life cycle cost per unit =

(P50,000 +(10,000 x P10) + P20,000) = P17 10,000

This cost/unit is above the target cost per unit, so the product is not worth making.

(c) Maximum total cost per unit = P15.

Some of this will be caused by the design and end of life costs:
(50,000 + P15,000 + P20,000)= P8.50 10,000 Therefore, the maximum manufacturing cost per unit would have to fall from P10 to (P15 - P8.50)= P6.50.

THANK YOU!!!