Overview: What is Life Cycle Costing?
This Life Cycle Costing Tool has been developed to assist asset managers in decision making based on performing a systematic assessment of the life cycle costs of selected water and wastewater assets.
Life Cycle Costing
Owners, users and managers need to make decisions on the acquisition and ongoing use of many different assets including items of equipment and the facilities to house them. The initial capital outlay cost is usually clearly defined and is often a key factor influencing the choice of asset given a number of alternatives from which to select.
The initial capital outlay cost is, however, only a portion of the costs over an asset’s life cycle that needs to be considered in making the right choice for asset investment. The process of identifying and documenting all the costs involved over the life of an asset is known as Life Cycle Costing (LCC).
The total cost of ownership of an asset is often far greater than the initial capital outlay cost and can vary significantly between different alternative solutions to a given operational need. Consideration of the costs over the whole life of an asset provides a sound basis for decision-making. With this information, it is possible to:
- Assess future resource requirements (through projection of projected itemized line item costs for relevant assets);
- Assess comparative costs of potential acquisitions (investment evaluation or appraisal);
- Decide between sources of supply (source selection);
- Account for resources used now or in the past (reporting and auditing);
- Improve system design (through improved understanding of input trends such as manpower and utilities over the expected life cycle);
- Optimize operational and maintenance support; through more detailed understanding of input requirements over the expected life cycle)
- Assess when assets reach the end of their economic life and if renewal is required (through understanding of changes in input requirements such as manpower, chemicals, and utilities as the asset ages).
The Life Cycle Costing process can be as simple as a table of expected annual costs or it can be a complex (computerized) model that allows for the creation of scenarios based on assumptions about future cost drivers. The scope and complexity of the life cycle cost analysis should generally reflect the complexity of the assets under investigation, the ability to predict future costs and the significance of the future costs to the decision being made by the organization.
A life cycle cost analysis involves the analysis of the costs of a system or a component over its entire life span. Typical costs for a system may include:
- Acquisition costs (or design and development costs).
- Operating costs:
- Cost of failures
- Cost of repairs
- Cost for spares
- Downtime costs
- Loss of production
- Maintenance costs:
- Cost of corrective maintenance
- Cost of preventive maintenance
- Cost for predictive maintenance
- Disposal costs.
A complete life cycle cost projection (LCCP) analysis may also include other costs, as well as other accounting/financial elements (such as, interest rates, depreciation, present value of money/discount rates, etc.).
For the purpose of this Tool, it is sufficient to say that if one has all the required cost values (inputs), then a complete LCCP analysis can be performed readily in a spreadsheet, since it really involves summations of costs for several options and computations involving discount rates. With respect to the cost inputs for such an analysis, the costs involved are either deterministic (such as acquisition costs, disposal costs, etc.) or probabilistic (such as cost of failures, repairs, spares, downtime, etc.). Most of the probabilistic costs are directly related to the reliability and maintainability characteristics of the system.
Why is Life Cycle Costing Important to a Utility?
An important component of a Utility’s activities is prioritizing the Capital Improvement Program, so that it can meet its most pressing needs. This prioritization occurs at the end of the capital project development process, which consists of Project Identification/Initial Validation, Risk Reduction, and Life Cycle Cost analysis, all of which are used to establish the final Business Case for each project. As can be seen in Figure 1, the Life Cycle Cost analysis is undertaken as part of the Business Case preparation.
The Life Cycle Cost analysis allows the Utility to examine projected life cycle costs for comparing competing capital and O&M project solutions and allows for appropriate comparison of alternatives of different capital values, and lengths of time.
Given the condition of the Utility’s assets, the amount of capital available from the budget, and historical evidence, the project manager must decide which project alternatives will incur the least life cycle costs over the life cycle of the assets involved while delivering performance at or above a defined level. As a result, this analysis will enable the Utility to:
- make decisions for capital and O&M investments based on least life cycle costs,
- rank each of the projects based on total cost of ownership,
- combine the costing data with the Project Validation (See the Capital Project Validation and Prioritization Tool for an in-depth discussion of project validation concepts and practices) and Risk Reduction (See the Business Risk Exposure Tool for an in-depth discussion of risk) scores to prioritize the projects,
- make more informed decisions, and
- allow better reporting to key stakeholders.
A thorough Life Cycle Cost analysis yields a higher level of confidence in the project decision, which is part of the Project Validation calculation. Combined with a Risk Reduction analysis to identify the risk reduction of various alternatives considered, the information from Life Cycle Cost preparation is summarized in a business case, providing a consistent approach to the review of projects.
Life Cycle Costing Methodology Used For This Tool
The life cycle of an asset is defined as the time interval between the initial planning for the creation of an asset and its final disposal. This life cycle is characterized by a number of key stages:
- Initial concept definition;
- Development of the detailed design requirements, specifications and documentation;
- Construction, manufacture or purchase;
- Warranty period and early stages of usage or occupation;
- Prime period of usage and functional support, including operational and maintenance costs, with the associated series of upgrades and renewal;
- The disposal and cleanup at the end of the asset’s useful life.
As shown in Figure 2, there are day-to-day, periodic and strategic activities that may occur for any asset. The asset life cycle begins with strategic planning, creation of the asset, operations, maintenance, rehabilitation, and on through decommissioning and disposal at the end of the assets life. The life of an asset will be influenced by its ability to continue to provide a required level of service. Many assets reach the end of their effective life before they become non-functional (regulations change, the asset becomes non-economic, the expected level of service increases, capacity requirements exceed design capability). Technological developments and changes in user requirements are key factors impacting the effective life of an asset.
Objectives of the Methodology
Life cycle costing (note: the terms “life cycle costing” and “life cycle cost projections” are used interchangeably in this Tool) analysis can be carried out during any phase of an asset’s life cycle. It can be used to provide input to decisions regarding asset design, manufacture, installation, operation, maintenance support, renewal/refurbishment and disposal.
The objectives of life cycle costing are:
- Minimize the total cost of ownership of the Utility’s infrastructure to its customers given a desired level of sustained performance;
- Support management considerations affecting decisions during any life-cycle phase;
- Identify the attributes of the asset which significantly influence the Life Cycle Cost drivers so that the assets can be effectively managed;
- Identify the cash flow requirements for projects.
Estimating Life Cycle Costs
The life cycle cost of an asset can be expressed by the simple formula:
Life Cycle Cost = initial (projected) capital costs + projected life-time operating costs + projected life-time maintenance costs + projected capital rehabilitation costs + projected disposal costs - projected residual value.
Note the prominent role of projected costs versus historic (actual) costs in analyzing life cycle costs; due to its forward looking “best guess” nature, life cycle costing is at least as much “systematic art” as it is analytical technique.
Impact of Analysis Timing on Minimizing Life Cycle Costs
A major portion of projected life cycle costs stems from the consequences of decisions made during the early phases of asset planning and conceptual design.
It is the early decisions made during the design of an asset, definition of operations and maintenance requirements, and setting of the operating context of the asset that commit a large percentage of the life cycle costs for that asset.
Figure 3 provides an indication of the level of cost reduction that can be achieved at various stages of the project. It shows that as a project moves from strategic planning that the majority of decisions have been made that provide the majority of the cost to the project.
The best opportunities to achieve significant cost reductions in life cycle costs occur during the early concept development and design phase of any project. At this time, significant changes can be made for the least cost. At later stages of the project many costs have become “locked in” and are not easily changed. To achieve the maximum benefit available during this stage of the project it is important to explore the following:
- A range of alternative solutions;
- The cost drivers for each alternative;
- The time period for which the asset will be required;
- The level and frequency of usage;
- The maintenance and/or operating arrangements and costs;
- Quantification of future cash flows;
- Quantification of risk.
The concept of the life cycle of an asset provides a framework to document and compare alternatives.
Selecting Potential Project Alternatives for Comparison
The intervention (or treatment) alternatives available to be considered include:
- Do-nothing - The Do-Nothing option is literally not investing any money on any form of maintenance or renewal, including that recommended by the design engineer or OEM vendor. This alternative is generally intended to set a conceptual baseline for asking the question: “What value does what we do now or what we plan to do add to extending the life/functionality/reliability of the asset over doing nothing at all?” Another way of looking at the core question posed here is, “Why should we continue to do what we do or are anticipating doing?” There are rather rare occasions when “Do Nothing” is a valid applied approach such as when an asset is due to be replaced or shut down in short order and additional maintenance/capital investment is irrelevant to keeping it running for the short period before it is to be decommissioned.
- Status Quo - The Status Quo option is defined as maintaining the current operations and maintenance behavior – typically that defined by the manufacturer or the design engineer. It is the realistic baseline case against which other alternatives are compared.
- Renewal (Major Repair, Rehabilitation or Replacement) - Assessment of different rehabilitation or replacement strategies requires an understanding of the costs and longevity of different asset intervention strategies. Each strategy is costed for the expected life of that strategy, converted to an equivalent present worth, adjusted for varying alternative life lengths, and compared to find the least overall cost.
- Non-Asset Solutions - In certain circumstances the non-asset solution (providing the same level of service without a major additional investment) can be a viable alternative (for example, using pricing strategies to reduce the consumption of water).
- Change Levels of Service - Most life cycle costing assumes a constant Level of Service across options being compared. When such is not the case (which is not infrequent in reality), comparisons across alternatives with different levels of service (that is, different levels of benefit) must intro duce a projected benefits section for each alternative in addition to the cost projections. This, of course, takes the analysis into the realm of benefit cost analysis (see the Benefit Cost Tool for much more discussion and tool support).
- Dispose - Disposal of the asset is retiring the asset at the end of its useful life. Perhaps the function or level of service originally desired from the asset is no longer relevant.
It is unlikely that all seven of the alternatives listed above are feasible for each analysis; rather than waste money on obviously irrelevant options, the practitioner is encouraged to reduce the analyzed set to only those that are thought to be feasible.
The Effect of Intervention
A single intervention option for the entire life cycle is not likely to be the best approach to maximizing the life extension for an asset. Multiple strategies and options will need to be studied to determine the optimal strategy or combination of strategies for maximum life extension.
Optimal Renewal Decision Making uses life cycle cost analysis as a core Tool for determining the optimum intervention strategy and intervention timing. See the “End of Asset Life” Reinvestment Tool or the Remaining Effective Life Tool for further discussion of concepts and practices in estimating the optimal time in the life cycle for reinvestment.
Estimating Future Costs
Knowing with certainty the exact costs for the entire life cycle of an asset is, of course, not possible; future costs can only be estimated with varying degrees of confidence. Future costs are usually subject to a level of uncertainty that arises from a variety of factors, including:
- The prediction of the utilization pattern of the asset over time;
- The nature, scale, and trend of operating costs;
- The need for and cost of maintenance activities;
- The impact of inflation;
- The opportunity cost of alternative investments;
- The prediction of the length of the asset's useful life.
The main goal in assessing life cycle costs is to generate a reasonable approximation of the costs (consistently derived over all feasible alternatives), not to try and achieve a perfect answer.
As rehabilitations and or replacement of assets occur during the life cycle, adjust both operations and maintenance costs appropriately. Both maintenance and operations costs are likely to materially increase as the asset ages. The pattern of increase will vary by asset type and operational environment [on many assets, as the asset ages, it requires an increasing number of visits per year by the maintenance team, longer time while at the asset to execute the work order, and often a higher level of maintenance staff to be deployed; these costs are both real and material and can be simply “modeled” in a spreadsheet (see the End-of-Asset-Life Reinvestment Tool for further discussion and demonstration)]. The timing of the rates of increases in the flow of costs over time are instrumental in determining total life cycle costs and can substantially impact the outcome of the investment decision. It is therefore important to:
- Be systematic, realistic and detailed in estimating the future flow of real costs
- Document in a notes section what the assumptions are
Inflation is likely to occur but should be taken into account in the discounting of future costs (see next section).
The Management of Cash Flow
The application of Life Cycle Cost analysis to find that alternative with the lowest life cycle costs is important, but there will also likely be organizational cash flow issues that need to be considered. There will always be competing demands for the available cash resources of the organization at any given time. Management of cash flow is simplified if the pattern is predictable over the long term. It is conceivable that the lowest cost solution might not be the best solution from the aggregate cash flow perspective.
Life cycle analysis provides a sound basis for projecting cash requirements which can assist the Chief Financial Officer in managing the cash cycles of the organization.
The Life Cycle Cost Projection Tool
The web based LCCP Tool developed as part of this WERF project is perceived as being at the forefront of life cycle costing analysis practices in the global water industry.
The focus of the establishment of this Tool has been on making it web based and enabling its’ usage by utility asset managers in the US – many of whom may be unfamiliar with the concept of life cycle costing in a formal methodological framework.
The Tool is designed to be interactive where a utility manager can either follow the LCCP process on a sequential step by step basis or, where a utility manager already understands the concepts of LCC, the Tool can be used to provide more detailed information on a particular aspect of the analysis.
LCCP Tool Structure
Users of the Tool should follow the flow chart through the various sequential steps of creating a life cycle cost analysis profile. At each step the user is able to access knowledge relevant to the particular step. The steps in the Tool are:
- Step 1 – Define Project Basics
- Step 2 – Develop LCCP Data For Each Project Option
- Step 3 – Analyze Each Option
- Step 4 – Document Analysis
- Step 5 – Review and Finalize LCCP Projections
The Tool has been structured to enable the user to sequentially follow a process to assist in preparing life cycle cost projections for several alternatives.