Friday, April 22, 2011
Life Cycle Costing Method
Costing is very important in an organization or a business entity. Without a system to identify the cost of the product an entity would not be able to analyze if a certain product or project is feasible or not, or if it advantageous with potential financial returns and not disadvantageous carrying losses with it. To identify the cost is to recognize an activity’s “expenditure, usually of money, for the purchase of goods or services” or to recognize “an expenditure, usually of money, incurred in achieving a goal, such as. producing certain goods, building a factory, or closing down a brand.” These are the definitions of cost provided by the A Dictionary of Business (1996, p.133) These costs can any of the following: current cost; economic cost; fixed cost; historical cost; marginal cost; opportunity cost; and/or replacement cost. These items are very relevant in cost accounting.
The “techniques used in collecting, processing, and presenting financial and quantitative data within an organization to ascertain the cost of the cost centers, the cost units, and the various operations” Hussey (1999, p.99) are termed as cost accounting. Presently cost accounting is regarded as a division of management accounting, which also incorporates the techniques of planning, decision-making, and control in the entity. In large organizations, the management team usually includes a cost accountant responsible for various costing needs and problems encountered by the company. One of them is the Life Cycle Costing
II. What is Life Cycle Costing (LCC)?
Life Cycle Costing, also known as the Whole Life Costing, is a costing technique to establish the total cost of ownership. As Defined in the A Dictionary of Business (1996, p. 292) it is the approach to determining the total costs of a fixed asset that takes into account all the costs likely to be incurred both in acquiring it and in operating it over its effective life.
For example, the initial cost to a plant or factory equipment is only part of the relevant costs to the decision to purchase it. The operating and maintenance costs over its effective life are also relevant and would therefore be part of the decision - making data. This is an aspect of terotechnology or s technology that encompasses management, financial, and engineering skills in installing, operating, and maintaining plant and machinery.
LCC is a structured costing method 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” (Life Cycle Costing). The outcome of an LCC analysis is very useful in assisting management in the decision-making process where there are choices of options. One factor that needs to be considered in this costing method however, is the accuracy of the analysis. As the time frame moves further into the future the accuracy of the analysis diminishes due to factors such as time value of money or inflation among others. Thus, it is very important to present a comparative tool when long-term assumptions apply to some options.
III. The Cost of Ownership
As mentioned, LCC totally accounts all costs in using an item. This cost “can be broadly divided into three categories: acquisition, running and disposal costs” Whole Life Costing (p.2). The following figure presents the cost of ownership.
Acquisition costs are incurred before the item, product or service is ready for implementation. On the other hand, running costs are those incurred as a result of actually utilizing the item, product or service or by simply keeping it available. Disposal costs are incurred, as the name suggests, costs incurred during disposal or when dealing with its potential contamination or other harmful effects of the item. This happens during the end of the life of the products.
There may also be some income that will be associated with or realized during the disposal phase of the item if a resale or residual value is available for that asset. This residual or resale income together with any rental or other income when assets are not in use (opportunity cost saved) can be used to offset against the costs in determining the whole life cost. The previous illustration presents some examples of the costs incurred on each phase of an asset’s life also known as the costs of ownership.
III. Application of LCC
The utilization and application of LCC is important for both end-users (clients) and suppliers (contractors). “LCC is based on the premise that to arrive at meaningful purchasing decisions full account must be taken of each available option.” (Life Cycle Costing) ” All significant aspect of the expenditure process regarding the use of resources which are likely to be incurred as a result of any decision must be addressed. Important considerations must be given to all relevant costs for each of the options, including opportunity costs, from initial consideration of a certain project until its disposal.
The level of complexity of LCC will vary also according to the respective complexity of the goods or product to be procured, contracted. Following are the common fundamental concepts to all applications of LCC:
a. Cost breakdown structure (CBS) which aims to identify all the relevant cost elements. CBS must also have well defined boundaries to avoid omission or duplication;
b. Cost estimation is a necessary procedure in LCC that may be determined by known factors or rates, cost estimating relationships (CERs) derived from accessible historical or empirical data and an opinion of some experts;
c. Discounting which is a technique used to compare costs with benefits that occur in various time periods; and
d. Inflation, which is not a necessary factor for LCC but may be considered. The inflation rate is not the discount rate.
Two good real life examples in the application of LLC are on government projects and procurement of equipments such as hospital equipments. Both the agencies mentioned (hospital and government agency) together with their respective project contractors would find LCC techniques very helpful in letting them decide on the feasibility and profitability of the projects. The better aspect of using LLC is on its “disposal phase” because sustainability is being thought of since the initial and during the entire process. Thus, when the disposal stage arrives, both the supplier and the client need not worry further on the environmental issues that the project may encounter.
Following are the statements taken from the published article on Achieving Sustainability by the Sustainability Action Group of the Government Construction Clients’ Panel of the United Kingdom (UK) government on how helpful it is to consider sustainability in government projects.
It clearly sets out how Government clients will take forward the sustainable development agenda through better procurement of new works, maintenance and refurbishment. This will deliver better value for money for occupiers, users and the public and will make clients and, in turn, suppliers fully aware of their responsibilities regarding sustainability.
Sometimes, in evaluating profitability versus market opportunity potential, decision-making process “often becomes more of an art than a management science” Eastaugh (1992, p.207) Decisions that must be made by hospital management is very important with regards to its reputation and continued existence. Eastaugh further emphasized the importance of using LCC in hospital projects:
The better hospital CEO would take the long-run perspective, consider life cycle costing, and concentrate on safeguarding the reputation of the institution. If one factors in the malpractice expense of mediocre performers, a big loss in the courts could more than wipe out 10 years of "cash cow" profits. Profitability should include some life-cycle costing adjustment for malpractice risk and facility reputation risk. Eastaugh (1992, p.207)
IV. The Use of LCC to Producers, Suppliers or Contractors
The primary consideration in the procurement of construction projects or the purchase of a long term asset is the need to obtain the best value for money or its equivalent “in the whole life” (Achieving Sustainability, 2000) of the facility or the service. This is the reason why it is best to utilize LCC in projects that require not only the setup but also require operation maintenance as well as disposal.
The design, function and operation of the project, be it a constructed plant or equipment, or facility or a rendered service should maximize the delivery of effective customer and public benefit and satisfaction. These goals are most likely to be achieved through a combination of the design, construction, operation and ongoing maintenance, appropriate procurement methods and proper setup and disposal that will deliver the best value for money against the inputs that the producer, supplier or service provider have invested.
“Design, construction, operation and maintenance should not be considered in isolation from each other” (Achieving Sustainability, 2000). Thus, with the use of LCC all the cost can be integrated and proper pricing on projects can be done leading to a competitive bid or to a successful project itself. LCC is a great help in developing strategies that identify the best way to achieve the objectives of the project and value for money, taking into account all of the possible risks and constraints such as maintenance and disposal which are not incorporated in normal costing method that accounts only for the acquisition cost. The strategies gained from using LCC will help the producers, suppliers or contractors to decide about the funding mechanism and asset ownership for the project. The use of LCC greatly assists in achieving the goal of the procurement strategies of the producer, supplier or contractor to achieve the optimum balance of risk, control and funding for a particular project.
V. LCC for the End Users
For an investment decision to be properly made, the decision maker, which is the management board of the entity, must have access to very important and relevant information. This is because the decision carries accountability. The relevant information that the decision makers need is on the cost of the planned project. Before deciding if the project is to be implemented or to be rejected, a proper costing is needed, a costing method that accounts for all the cost of the project since its inception until its disposal. This is where LCC comes in for the use of End-users or clients.
With the assistance of LCC, clients would be able to compare the cost data and make a proper decision when project bidders present their respective offers. Assessing the whole life cost of the project is essential, if the entity has a going concern objective. What the entity must know is not only the initial cash outlay or the investment cost but the entire cost of ownership of the project.
To fully understand what the project can give them, the client must be able to identify the ownership costs associated with the it. These costs are generally categorized as the following:
a. Acquisition costs are those incurred between the decision to proceed with the procurement and the entry of the goods or services to operational use
b. Operational costs are those incurred during the operational life of the asset or service
c. 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.
The use of LCC makes the entity secure and ready for all the potential expenditures the project can cause. This is much more important than to know the cost of the initial investment only which appears lower and more favorable but has not accounted for other costs of ownership or the entire cost during the lifetime of the asset.
VI. The Pros and Cons of LCC
Being something normal, the LCC has its own set of advantages and disadvantages. The following section enumerates and discusses the good side of using this system as well as its drawbacks.
a. The Advantages
LCC is a very powerful tool helping a lot of management decision-making processes in the financial world. Among the benefits of using this costing system, as stated in the book of B.H Dhillon entitled Life Cycle Costing are:
a. Useful to control program
b. An excellent tool for making a selection among the competing contractors
c. Beneficial in comparing the costs of competing projects
d. Useful in reducing the total cost
e. Useful in making decisions associated with equipment replacement
f. Useful in planning and budgeting
On the other hand, if one is to make an analysis of LCC, following are the four major benefits of LCC analysis as presented in the site of the Government Construction Clients’ Panel of the UK government entitled Life Cycle Costing:
g. LCC assists in the evaluation of competing options in purchasing such as competing proposals taking into account the cost all throughout the life cycle. LCC is mostly relevant in service contracts and decisions on equipment purchase
h. LCC improves awareness of total costs by taking into account factors that drive cost and their respective resources needed for a certain purchase
i. The application of LCC makes more accurate estimation of the full cost of a project leading to an improved decision making process for the management and establishment of support policies which are also cost effective. Long term costing assessments can have more accurate forecast for its future expenditures when using LCC.
j. Performance trade-off against cost is considered when using LCC. Factors such as requirement and quality must also be considered when purchasing an asset or hiring a service are thoroughly considered in LCC.
b. The Disadvantages
As previously mentioned, LCC is not perfect. Taken from the book of Dhillon, among the pitfalls of LCC are the following:
b. Time consuming
c. Accuracy of data is doubtful
d. Obtaining data is a trying task
Associated with one of the disadvantages of LCC is the lower visible cost of a purchased asset, which often misleads the decision makers. The costs that the majority usually notice, which is the acquisition cost represents only a small proportion of the total cost of ownership. In majority of the big businesses, many departments are within the big organization and the responsibility for the purchase of a certain asset and its acquisition cost is held by one department while the subsequent support funding are held by another department. This can be viewed as a clear limitation of using LCC. The decision makers do not see its benefits easily. Taken from a medical point of view, this fact is stated by Eastaugh in page 7 of his book, Health Care Finance: Economic Incentives and Productivity Enhancement:
Some medical technologies appear cost decreasing, such as visualizing gallstones with ultrasound and crushing the stones with lithotripsy. This is also clearly quality-enhancing in comparison to traditional exploratory surgery. Unfortunately, the public is not well versed in life-cycle costing or the risks of old style invasive medicine (with iatrogenic infections and prolonged lengths of stay). The media tend to focus excessive attention on initial capital outlays rather than on long-run cost-benefit and cost-effectiveness.
LCC is a very powerful tool that takes into account all the relevant cost when acquiring a product. This therefore have helped a lot of decision makers in deciding a lot of things when presented with various options to choose from. However, not everyone can utilize LCC due to some limitations such as its cost, accuracy, time needed to formulate it and the difficulties faced in acquiring the data needed to perform LCC.
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Achieving Excellence in Construction Procurement Guide. (2000). [Online]. Available at: http://www.ogc.gov.uk/documents/CP0066AEGuide6.pdf (Accessed: 11 May 2008)
A Dictionary of Business. 2nd ed. (1996). Oxford: Oxford University Press.
Dhillon, B. S. (1989). Life Cycle Costing. New York: Gordon and Breach Science Publishers.
Eastaugh, S. (1992). Health Care Finance: Economic Incentives and Productivity Enhancement. New York: Auburn House.
Hussey, R. (1999). A Dictionary of Accounting. 2nd ed. Oxford: Oxford University Press.
Life Cycle Costing. 2008. [Online]. Available at: http://www.ogc.gov.uk/implementing_plans_introduction_life_cycle_costing_.asp (Accessed: 11 May 2008).
Whole Life Costing. [Online]. Available at: http://www.eprocurementscotland.com/toolkit/Documents/Whole%20Life%20Costing%203.pdf (Accessed: 12 May 2008).
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