This article refers to Life Cycle Costing in terms of capital works funding programs only. An LCC approach to other areas of facilities management is also encouraged, however, since capital works tends to have the largest piece of the budget pie, then LCC methodology is an essential business practice.
What is Life Cycle Costing?
Life Cycle Costing (LCC) is a technique to establish the total cost of ownership (TCO) of a project. It is a structured approach that addresses all the elements of the TCO and can be used to produce a spend profile of the project over its anticipated – or functional – life-span. The results of an LCC analysis can be used to assist Facilities Leaders 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 upfront, visible costs of any purchase represent only a small proportion of the total cost of ownership. In many institutions, the responsibility for purchasing and subsequent funding of a major capital works project 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 departments are unlikely to apply the rigors of LCC analysis unless they see the benefit resulting from their efforts.
There are 4 major benefits of LCC analysis:
- 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 and technology purchasing decisions.
- Improved Awareness. Application of LCC techniques provides Facilities Leaders with an improved awareness of the factors that drive cost and the resources required by the project. 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 which would benefit from management involvement.
- Improved Forecasting. The application of LCC techniques allows the full cost associated with a capital project 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 maintenance policies. Additionally, LCC analysis allows more accurate forecasting of future expenditure to be applied to long-term financial assessments.
- Performance Trade-off against Cost. In all capital projects, 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, the quality of the finished product and the levels of service to be provided. LCC analysis allows for a cost/ benefit trade-off to be made against the varying attributes of the purchasing options.
Who is involved
In Higher Education, the investment decision maker (typically the Board of Regent’s or similar) is accountable to institutional stakeholders for any decisions relating to the cost of a project. The Facilities Department is responsible for ensuring that estimates are based on whole life costs and they are generally assisted by a Project Sponsor or Project Manager, as appropriate, together with additional professional expertise as required.
There are also tools involved. Traditionally, managers factored LCCs on Excel spreadsheets. While this works for smaller projects with a short time frame, the more major projects require complex solutions which track historical costs and other factors and can be used to develop scenario models against which LLCs can be used to assess financially viable alternatives. Today’s IWMS solutions have the capability not only to plan for capital works and contribute to the LLC model, but can also continue to serve as the maintenance and operational information platform for the project.
The cost of ownership of project is incurred throughout its whole life and does not all occur at the point of acquisition. Figure1 illustrates the spend profile showing how the costs vary with time. In most instances the disposal cost will be negative because the completed project is a facility which will have a resale value.
Figure 1: Facility expenditure profile over time
- 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. Depending on refurbishment, these operation costs will reduce as the facility is upgraded. The longer the facility goes without refurbishment, the higher the operational costs are likely to be.
- End life costs are those associated with the disposal, termination or replacement of the asset. In the case of assets, disposal cost can be negative because the asset has a resale value.
A purchasing decision normally commits the institution 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, however, with instruments such as OMB-A21, “ownership” can be assigned to users based on CIP Classification, which allows the operational costs to be recovered.
The principles of LCC can be applied to both complex and simple projects though a more developed approach would be taken for a large Capital Works project than a straightforward minor renovation project.
LCC involves identifying the individual costs relating to the procurement of the project. 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 facilities and assets age.
The types of costs incurred will vary according to type of project. Examples of one-off costs include: pre-planning, RFP/ bidding, documentation, project management, project facilities (offices) and running costs, consultant fees, end of life costs, etc. Examples of recurrent costs include: operating expense, occupying expense (life safety, environment, security), contract costs, downtime, transportation, special use costs, etc.
The Methodology of LCC
LCC is based on the premise that to arrive at meaningful purchasing decisions a full account must be made 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 of sophistication of LCC will vary according to the complexity of the project. 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
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 ;
- 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 lab construction 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 and will allow future reporting against OMB-A21 requirements;
- for projects 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.
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. 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 where costs 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 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’ where cost of capital today and its future value are expressed in terms of Discounted Cash Flow (DCF).
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.
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 the price of copper wiring 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.
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 occur). The risk allowance should be steadily reduced over time as the risks or their consequences are minimized through good risk management.
The sensitivity of cost estimates to factors such as changes in volumes, usage etc, need to be considered
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.
As the future unfolds, both public and private universities will continue to face increasing scrutiny over the way they are funding projects with increasingly scarce resources. Facilities leaders need to be able to defend their decisions to a wide ranging audience, and in doing so, win the support of executive leadership for expensive programs.
Developing an LCC analysis for all major purchasing decisions not only makes business sense, it also links clearly to the need for accountability within the institution and also to the greater stakeholder community. Stakeholders need to know that decision makers have made the best decision in light of all available information and have achieved at least the desired ROI. In the Higher Education arena, this goes even further. The LCC must be able to demonstrate that decision makers have not only made the right decision from a financial perspective, but also the right decision from the view of stakeholder expectations.
(c) 2009 Anthony R Stack
About the Author
Tony Stack is the Managing Director of BeyondFM. With over 25 years of facility management and real estate strategy and operations experience in the higher education and corporate world, Tony has worked with Facilities Leaders around the globe to develop business processes that position facilities groups as change leaders. He has been instrumental in the development of several large scale facilities strategies for Universities and Colleges based on demographic and economic change drivers and brings insight into the way technology and business process can be blended to enable and support change.
Tony is experienced in with multiple FM technologies (IWMS, CMMS, RRM) and their uses in a number of industries.