Whole Life Costing In Ownership Finance Essay - Free Essay Example

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. Cost planning cannot be effective unless the total costs are considered. For example, both the initial and future cost. Real Cost should encompass the initial acquisition costs and the running costs of maintaining costs of maintaining and operating a building throughout its effective life including refurbishment. Flanagan and Norman (1983) Life cycle cost of an asset is the total cost of that asset over its operating life, including the initial acquisition costs and subsequent running costs. Hoar and Norman Life cycle cost of an asset as the present value of the total cost of the asset over its operating life including initial capital cost, occupation costs, operating cost and the cost or benefit of the eventual disposal of the asset at end of its life. Life Cycle costing is refers to as ultimate life cost or total cost, a technique of cost prediction by which the initial constructional and associated costs and the annual running and maintenance costs of a building, or part of the building, can be reduced to a common measure. Life cycle costing = initial cost + maintenance cost + planting cost 2.2 Nature of Life Cycle Costing Life costing is employed as a design tool for the comparison of the cost of different designs, materials, components and constructional techniques. A valuable guide to the designer in obtaining value for money for the client. Used by property managers or developers to compare costs against the value accruing from future rents. Enables building functions to be expressed in terms of the costs of repairing and renewing the finishing and fittings, lighting and servicing and of the labour needed in operating the building. All the costs can be converted to present value (PV) by discounting techniques which makes it possible to combine all the costs of the building. Enable the vast range of factors on which judgment is necessary to be reduced to a comparison of a single cost with the personal assessment of the value of the building. Provide rationale for choice in circumstances where there are alternative means for achieving a giving object. In any economic appraisal one should not ignore the inevitable future upkeep costs necessary for a building to perform its complete function. The cost of maintenance must affect the true economic worth of a building in use. The relative importance of first and running costs is influenced by financial interest of the client. A developer will not usually consider the running costs. An industrialist will certainly influenced by the greater tax savings obtainable for running costs. An occupier will be more concerned with the total effect of the design upon the costs of owning and operating the building. 2.3 Why Life Cycle Costing is 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 benefit of LCC analysis: Evaluation of competing options in purchasing; Improved awareness of total costs; More accurate forecasting of cost profile; and Performance trade-off against cost Option Evaluation. LCC techniques allow evaluation of competing proposal on the basis of through life costs. LCC analysis is relevant to most service contracts and equipment purchasing decisions. Improved Awareness. Application of LCC techniq ues provides management with an improved awareness of the factors that drive costs and the resources required by the purchase. It is important that the cost drives 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 techiniques 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 services to be provide. LCC analysis allows for a cost trade-off to be made against the varying attributes of the purchasing options. 2.4 Who Will Involved? The investment decision maker (typically the management board) is accountable for any decisions relating to the cost of a project or programme. The Self-regulatory organizations (SRO) is responsible for ensuring that estimates are based on whole life costs and is assisted by the project manager, as appropriate, together with additional professional expertise as required. Principles The cost of ownership of an asset or services is incurred throughout its whole life and does not all occur at the point of acquisition. The figure give 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 o operational use. Operational costs are those incurred during the operational life of the assets or service End life costs are those associated with the disposal, termination or replacement of the assets or services. 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 throu gh-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, seeÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦ 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 importance to appreciate the difference between these cost groupings because one-off costs are sunk once the acquisition is made whereas recurring costs are time department and continue to be incurred throughout the life of the product or services. Furthermore, recurring costs can increase with time for example through increased maintenance costs as equipment ages. The type 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 and disposal. Examples of recurring costs include: Retaining; Operating costs; Services charges; C ontract and supplier management costs; Changing volumes; Cost of changes; Downtime/ non-availability; Maintenance and repair; and Transportation and handling. 2.5 The Methodology of Life Cycle Cost 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 decisions. Its claim 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 cost. 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. Know factors or rates: are inputs to the LCC analysis which have a know accuracy. For example, if the Unit Production Cost and quantity are know, then the Procurement Cost can be calculated. Equally, if costs of different grades of staff and the numbers employed delivering the services are know, the staff cost of services 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 produces by CERs must be treated with caution as incorrect relationships can lead to large LCC errors. Sources can include experience of si milar procurement 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. This guidance does not cover the topic in great detail as it is a produce 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 adjust to present time, i.e. the time when the decision is made. Discounting reduces the impact of downstream savings and as such 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 effect 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 reduces 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 balance out. The probability of these scenarios actually happening assessed and the expected expenditure adjusted accordingly. For more on optimism bias see the Green B ook. 2.6 Difficulties in Assessing Life Cycle Costs Difficulty of accurately assessing the maintenance and running costs of different materials, processes and systems. Great scarcity of reliable historical cost data and predicting the lives of materials and components is often fraught with dangers. QS rely on his own knowledge of the material or component or possibly on manufacturers data in the case of relatively new products. Example, Paint show variations and are influenced by type of paint, number of coats, condition of base and extent of preparation, degree of exposure and atmospheric conditions. Owners and occupiers maintenance produces may also vary considerably. Types of payments initial, annual and periodic requires a knowledge of discounted cash techniques. Tax has bearing on maintenance costs and needs consideration. Selection of suitable interest rates for calculations involving periods of up to sixty years is extremely difficult. Where projects are to be sold as an investment on completion, the client may show little interest in securing savings in maintenance and running costs. Where the initial funds available to the client are severely restricted, or his interest in the project is of quite short-term duration, little consequence that he can save large sums in the future by spending more on the initial construction. Future costs can be affected by changes of taste and fashion, changing statutory requirements for the buildings and the replacement of worn out components by superior updated items. Lives of different types of buildings are difficult to forecast with accuracy. 2.7 Practical Problems Which Affect Life Cycle Costing Life Cycle costing study is to prepare a cash flow schedule for the building including all the different user costs as they occur throughout the buildings life. Requires the life and maintenance profiles of components and materials to be prepared. Lives of building components can be predicted on the basis of observed rated of failure for existing buildings. However, it often shows substantial differences in the maintenance profiles of seemingly similar buildings. Main weakness is the large proportion of the construction techniques and components in a typical modern building. Collected data becomes out of date or is no longer applicable as new components and materials are introduced and possibly more innovative designs produced. Realistic life cycle costing profiles are very difficult to prepare. Many predictions and assumptions is of questionable validity. Changes in the basic prices of materials, components, labour and capital are difficult to forecast with accur acy and will affect all user costs. Sophisticated cost models incorporating many assumptions can be rendered invalid by changes in basic prices, unlikely to be uniform across the different components. Changes in government policy have far reaching effects on future needs and costs. Social, economic and technological changes are bound to have significant effect on the costs incurred throughout a buildings life and are all unpredictable at the time of preparing the life cycle costing plan. Emergency repairs and maintenance, arising from unforeseeable design faults or bad workmanship, constitute a significant proportion of maintenance costs, display a random pattern in both timing and extent, associated disruption costs can only be assessed in a very approximate form. Foreseeable maintenance work such as cleaning and redecoration, the actual decision as to the timing of the work depends to a considerable extent on management policy. Redecoration cycles vary significan tly to meet changing tastes and fashions, to implement a new colour scheme or on an unexpected change of occupancy. Longer cycles can result from financial constraints leading to deferment of the repainting and increasing substantially the cost the eventual work. Chapter 3: Hydraulic Elevator 3.1 Introduction 3.2 Hydraulic Elevator Component 3.3 Benefit for Hydraulic Elevator 3.4 Disadvantages for Hydraulic Elevator 3.5 Hydraulic Elevator Impact Chapter 4: Life Cycle Cost of Hydraulic Elevator 4.0 Introduction 4.1 Initial Cost 4.2 Planting Cost 4.3 Operating Cost 4.4 Maintenance Cost