Rational approaches to life cycle costing

May 18, 2006
It is the only rational way to make large, expensive purchases.

There is much talk about the idea of life cycle costing, a concept that should help anyone make an informed decision about replacing equipment. This month we seek out those non-commercial Web sites that provide relevant information. The idea behind life cycle cost is simple. It is the best method for measuring the value of a product over its life. You can then directly compare the values of each alternative you are considering because life cycle costing develops these values from a common basis.

In this context, value does not equal cost. Of course, the asset's acquisition cost goes into the life cycle cost, but it is not the only such cost to be included. The life cycle cost also includes factors such as the cost of maintenance overhauls and any routine upkeep of a more minor nature. Every factor that involves an outlay of cash or its equivalent is to be included in the life cycle cost calculations. The final transaction included in the calculations is the cash you receive or pay at the time you dispose of the asset.

Formalized approach

The folks at ASTM published method E-917, Standard Practice for Measuring Life-Cycle Costs of Buildings and Building Systems in 1994. ASTM may have written the book on the subject, but they do not make it easy to get a copy. If you go through the following exercise, you can read the scope of the standard. First, go to http://www.astm.org and click on the phrase "Enter ASTM Store." Then, click on "Search for Individual Standards" to get to the search engine. Enter the identifier for the standard--E917--and you see the title of the document. Click on the title and, voila, you see the scope and the pricing structure just in case you really want a copy of the unabridged version. Since the purpose of this column is to furnish you with useful, no-cost resources, this site was a dead end. Convinced that there is an awful lot of material out there for the asking, but finding it is not always easy, we search the Web so you don't have to.

Price is not value

An asset having a higher acquisition cost might also have a greater value that can, in the long run, justify the premium that purchasers pay. If the expensive asset requires significantly less maintenance, if it uses off-the-shelf repair parts, if it is has an extended service life, then it might make sense to pay more up-front in an expectation of reduced operating costs later. Life cycle costing methodology evaluates this purchase decision.

As an example of life cycle costing in the real world, the Capital District Business Review posted an article that describes the use of life cycle costing on highway bridges at http://search.amcity.com/albany/stories/102097/focus6.html.

Jim Mulvaney, Jr. gives a simplified example of this concept at http://webcreate.com/floors/pages/tips/tips.html. Although his Web site centers on carpeting, the general principles apply to the industrial arena. The primary shortcoming of the page is that Mulvaney does not go into the net present value calculations. I suppose that is justified since he appears to be marketing to households.

Net present value

The rigorous application of life cycle costing requires that the relevant future cash flows be discounted to convert them to current dollars. Since present values are highly sensitive to the discount rate, selecting that variable is the key element in the calculations. The discount rate is not simply the cost of debt or the interest rate your bank quotes. There are several other variables to be considered. Our friends at the agribusiness school at the University of Arkansas show how to calculate the discount rate on the basis of the cost of equity, tax rate, proportion of long-term debt in the firm, and other factors. Look for the calculations at http://www.uark.edu/campus-resources/agrifin/hndout10.html.

As one Web site put it, "LCC helps engineers think like MBAs and act like engineers for making the correct selection of equipment for achieving the lowest long term cost of ownership to generate wealth for stockholders." The discipline of engineering economics is brought to life at a Web site hosted by Iowa State University. When you visit them at http://www.public.iastate.edu/~inde304/homepage.html, click on some of the icons and explore. The tutorial icon gets you started on a refresher course covering the calculations for net present value.

A very nice Web site aimed at smaller businesses is called the Business Owner's Toolkit--total know-how for small business. This site pasts another tutorial on major purchases and projects. It is a multi-page, sequential presentation with icons at the bottom of each page that let you move in either direction. A good place to start is http://www.toolkit.cch.com/text/P06_6000.stm. When you have mastered the intricacies of the purchasing process, click on the home icon to access the rest of what this site offers. Then, pass the URL to any small business owners you might know.

Peter Wilcoxen at the Department of Economics at The University of Texas at Austin also goes into present value calculations. His site is located at http://www.eco.utexas.edu/Homepages/Faculty/Wilcoxen/enr/notes/pv.shtml. However, Dr. Ken Collier at Northern Arizona University posts a PowerPoint presentation that covers the issue well. This presentation is only a small part of a larger body of Web work that augments a design course at the school. Be sure to explore a bit when you visit http://www.cse.nau.edu/~synthesis/Path_to_Synthesis/EGR286/Course_

Cost analysis and strategy assessment

If your company is contractor under a current U.S. government contract, you can obtain a copy of version 4.0 of a software package called CASA, an integrated suite of analysis tools for collecting, manipulating, and reporting life cycle cost data. In addition to life cycle costing, the package performs sensitivity analysis, risk analysis, and more. You can register on-line to get the software, but being that we are talking about the government here, you do not get an instant download of the software. It takes some unspecified amount of time to process your request. Then you get an e-mail message that tells you the request has been processed. If you qualify and you have too much time on your hands, go for it. Visit http://www.logpars.army.mil/casa/

Free software

Not everyone wants to deal with our hired hands in Washington, but everyone likes a freebie. Barringer & Associates offers software that demonstrates how to use random numbers to determine life cycle cost. If this sample version of the software works for you, of course you can get its big brother for a few dollars. The 905 K file expands to 6 meg and is available at http://www.barringer1.com/lcc.htm.

Ziff-Davis offers free software as well. First, go to http://www.zdnet.com and click on the word "downloads" at the left of the page. Then, enter the phrase "life cycle cost" in the search input line. Hit enter and you will be presented with the option of downloading something called Life Cycle in three versions--Windows NT, 3.x, and 95. From there, it is up to you.

Life cycle cost of a career?

One Web page claims that it is possible to attach a life cycle cost to a career. I am not sure that I agree with the conclusion the author makes. It is worth a visit, but only when you are at your wit's end. Visit http://www3.geocities.com/Athens/Delphi/5655/r0298/0205-3.html.

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