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Least Cost Analysis

The essence of responsible asset management is choosing the right option, which requires sound asset management processes, appropriate information systems, and adequate data.

The key result of ORDM is to derive the greatest benefit for the resources invested in meeting the business objectives of our organizations.

ORDM is not a process for Economic Evaluation. It is a process that attempts to ensure that:

All options to overcome the mode of failure are considered
Intervention levels are determined for different treatment options
All benefits are equally assessed, for example:
- Risk exposure
- Probability of failure
- Life extension.

Each treatment option and its associated discounted cash flow or cost/benefit then needs to be assessed economically using the organization's policy on economic evaluation technique.

This assessment of business risk cost should be done on a NPV cost benefit analysis basis. For the purposes of ranking the work, the organization should determine what is an acceptable cost benefit ratio e.g. +1.25 or relevant return on investment or discount rate.

The review should then determine the date at which the proposed works would reach this cost benefit especially in the case where risk will increase with time and therefore a future prediction of the date at which a return would be achieved. This date can then be used to determine the future necessary cash flow.

The objective is to determine only those works that constitute an unacceptable risk to the organization. This may mean passing up opportunities to make investments that may have a benefit in terms of extending life, etc.

The outputs that need to be derived require the following inputs:

Quantifying the consequences of failure in $ terms
Extending the costs to avoid or reduce this consequence substantially
Determining the current risk cost by using an appropriate probability.

The outputs should enable an organization to be able to identify the point at which the cost/benefit ratio reaches +1.25 or where the NPV becomes positive at the discount rate required by the organization for renewal/investment analysis.

It is in this area that it is important to develop the basis of a future optimized renewal decision making model.

Risk costs

A philosophical issue arises when determining the preferred intervention date. Should the organization consider both the direct and indirect costs?

If the current business environment (profitability) of the organization is okay then the answer should be yes. (We must do this if our philosophy is to deliver a commercial customer-focused minimum cost service).

If the financial situation (viability) is critical then the answer may be different.

We may be using a high discount rate (e.g. 15%) to restrict the use of capital. This will impact on the ORDM decision significantly.

Another technique is to use a different discount rate to assess the NPV of the indirect risk (ancillary) element of the cost predictions. E.g. increase or double the discount rate used to assess the direct costs.

If we are unsure of the probability of failure we should look at the sensitivity of this input, and after running several scenarios, revise our decisions accordingly.

Discount factors

The whole intention of ORDM is to choose the renewal strategy that best suits the organization's business environment and the asset itself.

We are trying to identify the best strategy e.g. the lowest cost option for the asset at a certain point in time. It is vital that we attempt to find this "optimal strategy".

In the past we have often used DCF to show how rehabilitation is not as cost effective as replacement, and then showing how replacment before failure is less cost effective than waiting until after failure.

When developing future strategies for assets it is vital that we don't miss the optimal intervention point.

Many asset managers are concerned that high discount rates have and will result in all long lived assets being run down to levels where optimal intervention points are passed and then cannot be considered.

To help with this, it is recommended that all ORDM strategy analysis is completed using a discount rate of 4% (maximum). This should be used to determine individual strategies, which are then inserted into the TAMPs.

These TAMPs and their associated renewal cash flows are then used to produce the average annual annuity or income required to sustain the existing assets and the service they need to deliver. This could also include new assets and services required.

Then a higher discount rate e.g. 10% or 12%, can be used to prioritize or reallocate the works program until the organization is in a financially viable state and can afford the lowest life cycle cost or optimal program determined by ORDM and included in the TAMP.

Economic evaluation of options

In evaluating the various renewal options available we need to ensure that the following principles and key inputs are adhered to, namely:

Like period

That the costs and benefits are assessed over an identical period to ensure that recurrent events are fully covered. This is particularly true where replacement scenarios are included in the ORDM.

Identify all costs

It is essential that we identify all costs and the changes in costs that are likely over this economic period and don't allow invalid assumptions such as "reduce maintenance by 90%" to be constant for the period when in fact maintenance will again rise on the rehabilitated option asset sometime after the rehabilitation has taken place.

For this purpose, a typical ORDM model enables people to assess costs over the significant periods of up to 120 years.

Of course the discounted value of money over such periods will have a dramatic effect on the potential cost benefits however it is important that we consider the full period, as significant costs in secondary rehabilitation or the replacement of other components can significantly alter our renewal strategies.

Economic (investment) evaluation

It is often argued that an economic evaluation (including ORDM) should include items such as depreciation and interest and redemption on loans taken out to finance the works.

Organizations often query why "replacement" may result in more benefit than "maintaining status quo". When money has to be borrowed to fund the replacement these people are mixing financial viability (cash flow) with economic evaluation.

It becomes very complicated once we mix both financial and economic evaluation together.

But if it is to be included then we have to also consider:

The interest payment which has to be capitalized
That the interest payment may be tax-deductible (depending on tax laws)
Depreciation of assets.

All these are not considered in pure economic evaluation as they are considered as accounting terms, which are used for financial appraisal rather than investment appraisal.

Also, in economic evaluation we use one single long-term opportunity cost of capital. In financial evaluation, the interest rates can vary depending on the timing, the funding mix (debt-equity) and the risk the banker perceived.