Final - Life Cycle Costing

8/3/2019 Final - Life Cycle Costing

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Reporters:

Malabaguio, Reymark

Merca, Rossel

nej26


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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.


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The results of an LCC analysis can be used toassist 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.


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Why is it important?

The visible costs of any purchase represent only asmall proportion of the total cost of ownership. Inmany departments, the responsibility for

acquisition cost and subsequent support fundingare held by different areas and, consequently,there is little or no incentive to apply theprinciples of LCC to purchasing policy. Therefore,

the application of LCC does have a managementimplication because purchasing units are unlikelyto apply the rigours of LCC analysis unless they seethe benefit resulting from their efforts.


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There are 4 major benefits of LCCanalysis:

evaluation of competing options inpurchasing;

improved awareness of total costs;

more accurate forecasting of cost profiles; and

performance trade-off against cost.


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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.


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Improved Awareness.

Application of LCC techniques providesmanagement with an improved awareness of thefactors that drive cost and the resources required

by the purchase. It is important that the costdrivers are identified so that most managementeffort is applied to the most cost effective areasof the purchase. Additionally, awareness of the

cost drivers will also highlight areas in existingitems which would benefit from managementinvolvement.


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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 moreaccurate forecasting of future expenditure to

be applied to long-term costings assessments.


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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 varyingattributes of the purchasing options.


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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, togetherwith additional professional expertise as

required.


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Principles

The cost of ownership of an

asset or service is incurred

throughout its whole life anddoes not all occur at the point of

acquisition. The Figure gives an

example of a spend profile

showing how the costs vary withtime. 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.


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Acquisition costs are those incurred between

the decision to proceed with the procurementand the entry of the goods or services tooperational use

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

End life costs are those associated with thedisposal, termination or replacement of the

asset or service. In the case of assets, disposalcost can be negative because the asset has aresale value.


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A purchasing decision normally commits the

user to over 95 per cent of the through-lifecosts. 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 alarge PFI project than a straightforward

equipment purchase.


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The Process

LCC involves identifying the individual costsrelating to the procurement of the product orservice. These can be either "one-off" or

"recurring" costs. It is important to appreciate thedifference between these cost groupings becauseone-off costs are sunk once the acquisition ismade whereas recurring costs are timedependent and continue to be incurred

throughout the life of the product or service.Furthermore, recurring costs can increase withtime for example through increased maintenancecosts as equipment ages.


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The types of costs incurred will vary according to thegoods or services being acquired, some examples are givenbelow.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


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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.


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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 islikely to arise as a result of any decision must

be addressed. Explicit consideration must be

given to all relevant costs for each of theoptions from initial consideration through to

disposal.


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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, andwhere the same items are procured frequently

a cost database can be developed.


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The following fundamental concepts are commonto all applications of LCC:

cost breakdown structure;

cost estimating;

discounting; and

inflation.


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Cost breakdown structure (CBS)

CBS is central to LCC analysis. It will vary in

complexity depending on the purchasingdecision. Its aim is to identify all the relevant

cost elements and it must have well defined

boundaries to avoid omission or duplication.


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Whatever the complexity any CBS should have

the following basic characteristics: it must include all cost elements that are

relevant to the option under considerationincluding internal costs;

each cost element must be well defined sothat all involved have a clear understanding ofwhat is to be included in that element;

each cost element should be identifiable witha significant level of activity or major item ofequipment or software;


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the cost breakdown should be structured in

such a way as to allow analysis of specificareas. 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 willallow costs to be fed directly to the LCC

analysis;


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for programmes with subcontractors, these

costs should have separate cost categories toallow close control and monitoring; and

the CBS should be designed to allow differentlevels of data within various cost categories.

For example, the analyst may wish to examinein considerable detail the operator manpowercost whilst only roughly estimating themaintenance manpower contribution. TheCBS should be sufficiently flexible to allow costallocation both horizontally and vertically.


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Cost Estimating

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

known factors or rates: are inputs to the LCCanalysis which have a known accuracy. Forexample, if the Unit Production Cost and quantityare known, then the Procurement Cost can becalculated. Equally, if costs of different grades of

staff and the numbers employed delivering theservice are known, the staff cost of servicedelivery can be calculated;


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cost estimating relationships (CERs): are derivedfrom historical or empirical data. For example, if

experience had shown that for similar items the costof Initial Spares was 20 per cent of the UPC, thiscould be used as a CER for the new purchase. CERscan become very complex but, in general, the

simpler the relationship the more effective the CER.The results produced by CERs must be treated withcaution as incorrect relationships can lead to largeLCC 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 ITwhere can soon become out of date; and.


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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 theassumptions and rationale that support the

opinion.


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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 timepreference.


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When comparing two or more options, acommon base is necessary to ensure fairevaluation. As the present is the most suitabletime reference, all future costs must beadjusted to their present value. Discounting

refers to the application of a selected discountrate such that each future cost is adjusted topresent time, i.e. the time when the decisionis made. Discounting reduces the impact of

downstream savings and as such acts as adisincentive to improving the reliability of theproduct.


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Inflation

It is important not to confuse discounting and

inflation: the Discount Rate is not the inflation

rate but is the investment "premium" overand above inflation. Provided inflation for all

costs is approximately equal, it is normal

practice to exclude inflation effects whenundertaking LCC analysis.


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However, if the analysis is estimating the costs of

two very different commodities with differinginflation 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 vendors proposal may

already include a provision for inflation and,

unless this is noted, there is a strong possibilitythat an additional estimate for inflation might be

included.


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Risk assessment

Cost estimates are made up of the base

estimate (the estimated cost without any risk

allowance built in) and a risk allowance (theestimated consequential cost if the key risks

materialize). The risk allowance should be

steadily reduced over time as the risks or theirconsequences are minimized through good

risk management.

Other issues


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Sensitivity

The sensitivity of cost estimates to factors

such as changes in volumes, usage etc need to

be considered


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Optimism bias

Optimism bias is the demonstrated systematictendency 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.


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An LCC analysis allows the designer to studythe effect of using different componentswith different reliabilities and lifetimes. Forinstance, a less expensive battery might be

expected to last 4 years while a moreexpensive battery might last 7 years. Whichbattery is the best buy? This type ofquestion can be answered with an LCCanalysis.


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The LCC analysis consists of finding the present

worth of any expense expected to occur over thereasonable life of the system. To be included in theLCC 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 beestimated with reasonable confidence; but, the

cost of pollution caused by the generator mayrequire an educated guess. Also, the competingpower systems will differ in performance and

reliability.


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To obtain a good comparison, the reliabilityand performance must be the same. Thiscan be done by upgrading the design of the

least reliable system to match the poweravailability of the best. In some cases, youmay have to include the cost of redundantcomponents to make the reliability of thetwo systems equal.


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LCC Calculation The life-cycle cost of a project can be calculated

using the formula:

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

where the pw subscript indicates the present worthof each factor.


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

The capital cost (C) of a project includes the initialcapital expense for equipment, the system design,engineering, and installation. This cost is alwaysconsidered as a single payment occurring in the initial

year of the project, regardless of how the project isfinanced.

Maintenance (M) is the sum of all yearly scheduledoperation and maintenance (O&M) costs. Fuel orequipment replacement costs are not included. O&Mcosts include such items as an operator's salary,inspections, insurance, property tax, and all scheduledmaintenance.


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The energy cost (E) of a system is the sum of the yearlyfuel cost. Energy cost is calculated separately fromoperation 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 lifeof the system. The replacement of a battery is a good

example of such a cost that may occur once or twiceduring the life of a PV system. Normally, these costsoccur in specific years and the entire cost is includedin those years.



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The salvage value (S) of a system is its networth in the final year of the life-cycle

period. It is common practice to assign asalvage value of 20 percent of original costfor mechanical equipment that can be

moved. This rate can be modifieddepending on other factors such asobsolescence and condition of equipment.



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Future costs must be discounted because of thetime 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 earninterest. Future sums of money must also bediscounted because of the inherent risk of future

events not occurring as planned. Several factorsshould be considered when the period for an LCCanalysis is chosen.


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sample First is the life span of the equipment. PV modules

should operate for 20 years or more withoutfailure. To analyze a PV system over a 5-year period

would not give due credit to its durability andreliability. Twenty years is the normal periodchosen to evaluate PV projects. However, most

engine generators won't last 20 years soreplacement costs for this option must be factoredinto the calculation if a comparison is to be made.


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The discount rate selected for an LCC analysis hasa large effect on the final results. It should reflectthe potential earnings rate of the system owner.

Whether the owner is a national government,small village, or an individual, money spent on aproject could have been invested elsewhere and

earned a certain rate of return. The nominalinvestment rate, however, is not an investor's realrate of return on money invested.


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Inflation, the tendency of prices to rise over

time, will make future earnings worth less.Thus, inflation must be subtracted from aninvestor's nominal rate of return to get the netdiscount rate (or real opportunity cost of

capital). For example, if the nominalinvestment rate was 7 percent, and generalinflation was assumed to be 2 percent over theLCC period, the net discount rate that should

be used would be 5 percent.


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Different discount rates can be used for different

commodities. For instance, fuel prices may beexpected to rise faster than general inflation. Inthis case, a lower discount rate would be used

when dealing with future fuel costs. In the

example above the net discount rate was assumedto be 5 percent. If the cost of diesel fuel wasexpected to rise 1 percent faster than the generalinflation rate, then a discount rate of 4 percent

would be used for calculating the present worth offuture fuel costs.


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You have to make an estimate about future rates,realizing that an error in your guess can have alarge affect on the LCC analysis results. If you use adiscount rate that is too low, the future costs will

be exaggerated; using a high discount rate doesjust the opposite, emphasizing initial costs overfuture costs. You may want to perform an LCCanalysis with "high, low and medium" estimates on

future rates to put bounds on the life-cycle cost ofalternative systems.


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Formulas1. The formula for the single presentworth (P) of a future sum of money (F)

in a given year (N) at a given discountrate (I) is

P = F/(1 + I)N.


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2. The formula for the uniform presentworth (P) of an annual sum (A)

received over a period of years (N) at agiven discount rate (I) is

P = A[1 - (1 + I)-N]/I.


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As mentioned, target costing placesgreat emphasis on controlling costs bygood product design and productionplanning, but those up-front activities

also cause costs. There might be othercosts incurred after a product is soldsuch as warranty costs and plant

decommissioning.


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When seeking to make a profit on a

product it is essential that the totalrevenue arising from the productexceeds total costs, whether these costs

are incurred before, during or after theproduct is produced. This is the conceptof life cycle costing, and it is importantto realize that target costs can be drivendown by attacking any of the costs thatrelate to any part of a products life.


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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, machineset up, inventory, training, production machinemaintenance and depreciation

Operation Distribution, advertising and warrantyclaims

End of life Environmental clean-up, disposal anddecommissioning


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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 differenttimes. A committed cost is a cost that will be incurred

in the future because of decisions that have alreadybeen made. Costs are incurred only when a resource isused.


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Attention to all costs will help to reduce the cost perunit and will help an organization achieve its targetcost.

Many costs will be linked. For example, more attentionto design can reduce manufacturing and warrantycosts. More attention to training can reduce machinemaintenance costs. More attention to waste disposal

during manufacturing can reduce end-of life costs.


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Typically the following pattern of costs committed

and costs incurred is observed:


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The diagram shows that by the end of the design phase

approximately 80% of costs are committed.For example, the design will largely dictatematerial, labor and machine costs. The company cantry to haggle with suppliers over the cost ofcomponents but if, for example, the design specifies 10units of a certain component, negotiating withsuppliers is to have only a small overall effect on costs.A bigger cost decrease would be obtained if the designhad specified only eight units of the component. The

design phase locks the company in to most future costsand it this phase which gives the company its greatestopportunities to reduce those costs.

i l l f d lif


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A numerical example of target and life

cycle costing:

A company is planning a new product. Market researchinformation suggests that the product should sell 10,000 units atP21.00/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.


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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?


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

follows:

(a) Cost + Mark-up = Selling price

100% +40% = 140%

P15+ P6 = P21


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(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.


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(c) Maximum total cost per unit = P15.

Some of this will be caused by the design and endof life costs:

(50,000 + P15,000 + P20,000)= P8.50

10,000

Therefore, the maximum manufacturing cost per unitwould have to fall from P10 to

(P15 - P8.50)= P6.50.


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THANK YOU!!!

Final - Life Cycle Costing

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