Life Cycle Analysis and Costing
This topic has a brief overview and covers:
Output budgeting requires that the total cost of owning an asset be known. Asset costs are input costs to service delivery output. They must be known to ascertain the performance of the asset and of the service delivery output.
The figure below shows that the total cost of owning the asset includes the costs of planning, design, procurement and construction, depreciation, return on equity, maintenance and operating costs throughout its projected life, refurbishment and renewal, and disposal costs.
An asset proceeds through a number of sequential phases during its life cycle – acquisition, operation and maintenance, refurbishment or enhancement, and, finally, disposal.
The life cycle of an asset begins with a planning process that identifies the need for the asset and determines how and when it is to be procured.
The asset is then acquired – either an existing asset is purchased or a new one is created. The asset then enters its operational phase.
As the asset ages, it may deteriorate or become obsolete, at which stage a decision is made to either refurbish, enhance or dispose of it. If the need still exists for the service provided by the asset, the cycle recommences.
Asset planning
During this phase, the need for the asset is established and the method of acquisition is determined.
Create or acquire asset
During this phase, an asset is either constructed or acquired. If acquired, the asset may be either new or second-hand.
A constructed asset may be custom designed and built to meet delivery requirements. A degree of flexibility may be incorporated in the design to cater for future organizational or process changes, and the extent of such flexibility should be determined by life cycle planning.
Operate and maintain asset
During this phase, the asset should be maintained in a condition that matches the service delivery demands placed on it. This includes routine maintenance (preventive and corrective) as well as major periodic maintenance.
Operating costs, such as energy and cleaning costs, statutory charges and management costs, will also be incurred during this phase, and will be identified in the Life Cycle Plan.
Refurbish or enhance asset
Even with an effective routine maintenance program, an asset will gradually deteriorate as a result of wear and tear, or it will become obsolete owing to changes in technology and user requirements.
If the asset is to continue to support service delivery effectively, it will require refurbishment or enhancement; the timing and extent of this should be assessed through life cycle planning. (It should be noted that a refurbishment does not necessarily increase the service potential of an asset or extend its design life).
Dispose of asset
During this phase, the organization divests itself of the asset. This usually occurs when the asset is no longer useable or when its disposal makes a greater economic contribution to the agency than its retention.
In using a life cycle planning approach in managing an asset, it must be recognised that a decision taken at a particular stage of an asset’s life needs to be considered in the light of what effect the decision will have on all other stages of the asset’s life cycle.
For example, where a decision is made that an asset is to be disposed of in the near future, it would be appropriate to reduce the maintenance undertaken on it to decrease operating costs. However, sufficient maintenance would still need to be carried out so that the disposal value of the asset is not lost, and that statutory obligations continue to be met.
Several factors influence the effective life of an asset. Some of these, such as the asset’s condition, are intrinsic to the asset itself. Others relate to its purpose (e.g. if the service for which the asset was acquired is no longer provided, then the asset may be no longer useable). Monitoring the performance of assets to confirm or amend their expected useful life is an important part of strategic asset management.
Some key issues to be considered in assessing the useful life of an asset are:
Physical factors
If the facility has been neglected or consistently under-maintained, major rectification or repair works may be needed. In such a case, life cycle costing should be employed to test the relative merits of repair or replacement.
Assets can become unusable if parts can no longer be procured. When this occurs, the asset becomes obsolete for technical reasons.
Excessive operating costs may mean that an asset no longer meet acceptable standards for energy consumption, or they may incur high labour costs for routine operation.
If the facility is incapable of being economically modified to meet these requirements (e.g. to provide access for the disabled), its effective life is reduced.
Operational factors
The asset may be poorly located in relation to customer need, public transport routes or demographic shifts.
The asset may be unable to accommodate currently required functions, such as computer cabling, security systems, production plant, loading docks or public access.
There may have been such an increase in service demand that the asset's capacity cannot meet it. Expansion of the facility on its existing site may not be possible.
The internal operations may be inefficient because the spaces are unsuited to the contemporary style of operation.
The above factors, and others, can influence the effective life of an asset. Periodic reassessment of current and projected asset performance is desirable to detect changes early enough for plans to be made for refurbishment, replacement or disposal.
Life cycle data can be obtained from reports on asset performance and from accounting records. (Cost details should be recorded in a consistent manner if life cycle planning processes are to be properly implemented.)
Asset reporting must include all the information needed to assess the performance of the asset and its expected life. This information should be produced on a routine basis and include at least:
Information on asset condition
Condition surveys can provide information on the physical condition of an asset and identify its future maintenance requirements. It is important to ensure that the condition is assessed against realistic standards that derive from the use to which an asset is put. As an example, laboratories in a university do not need to be maintained to the same level as a hospital operating theatre.
Detailed defect information is not always necessary in assessing condition. Excessive detail should be avoided in condition reports.
Information on asset utilization
Utilization rates can provide information on the intensity of use of an asset. Such information is an important factor in life cycle planning as it assists in making decisions on the future use of an asset. For example, high utilization rates may flag the impending need for enhancement or expansion, or for demand management practices to be considered. Low utilization rates suggest that there is surplus capacity that could be exploited, or that the service could be provided elsewhere and the asset disposed of.
Utilization rates can be measured objectively as units produced against capacity, or working hours per week. Utilization is measured against the theoretical maximum capacity of the asset when working continuously at maximum efficiency.
Information on asset functionality
It is useful to know the functionality (or ‘fitness for purpose’) of an asset. It may be in very good condition, but fulfill its service delivery role very badly, because of changing patterns of service need, technological change, or imperfect design in the first place.
Judgment is needed to assess the functionality of an asset, and the assessment may not necessarily be quantitative. Users, who have the responsibility for delivering the service that the asset is designed to support, best make this evaluation.
Financial information
Base financial information, such as the current valuation, depreciation for the current period, and capital charge (if relevant), is needed by those making decisions about assets. Current period operational expenditure, such as that incurred for energy use, cleaning, maintenance and management, should also be available, so that realistic projections of future costs can be made.
Accounting Policy Impacts
Consistency of cost data is important when undertaking life cycle planning. The impact of accounting policies needs to be considered.
Valuation data
It is widely accepted that traditional valuation techniques (based on historic cost) add little to the stock of information needed for decision-making about assets.
The deprival value methodology has been recognized as being the appropriate method to determine current value. The deprival value of an asset is the value to the agency of the future economic benefits that the agency would forego if deprived of that asset.
Under this approach, assets are valued at an amount that represents the cost that might be expected to be incurred if the organization was deprived of the future economic benefits of those assets.
Depreciation data
Traditional techniques of depreciating assets on a straight-line basis involve making a ‘best guess’ about the life of the asset and an estimate of its residual value.
Often these computations do not reflect the real position, and do not take the physical condition of the asset into account.
Current thinking is moving towards a ‘condition-based’ depreciation method, where the existing depreciation calculation is supplemented with a provision that takes account of known major periodic maintenance.
All of the above information is necessary to develop realistic assessments of asset life, and hence to identify preferred options as part of the life cycle management process.
Life cycle costing
The primary technique used in life cycle planning is life cycle costing – a widely used method of economic evaluation of any asset, including buildings and their components.
In other words, life cycle costing assembles all costs incurred (or likely to be incurred) by an asset over its projected life, so that they can be analyzed and evaluated. This enables decisions on acquisition, maintenance, refurbishment or disposal to be made in the light of full cost implications.
The discounted cash flow method is used to analyze and evaluate the life cycle costs of an asset. This method appraises projects based on the concept of ‘discounting’ future costs and benefits to their Net Present Value. The Net Present Value is calculated using the method of compounding interest, and the rate by which the Net Present Value is computed is known as the discount rate.
The rationale of this method is based on the fact that a dollar now is worth more than a dollar next year (i.e. the value of money decreases as time passes). As a result, expenditures in the early years of a project’s life are very significant, while the same expenditures in the future have less purchasing power.
Benefit/Cost analysis
Benefit–Cost analysis is a technique that can be used as an alternative to life cycle costing in life cycle planning process. It is similar in concept to life cycle costing, but has two differences.
Benefit–Cost analysis also takes into account:
- The benefits of the proposed course of action, as well as the costs
- The overall costs and benefits to society as a whole, and not simply the financial effect on the organization.
There are, however, practical constraints on using Benefit–Cost analysis. The costs and benefits generated by an activity over time must be assigned a money value. These values are then converted to present day values (using the discounted cash flow method) in the same way as is done for life cycle costing. However, some costs and benefits are intangible and therefore difficult to measure directly.
Benefit–Cost analysis is not an everyday working tool for the purposes of life cycle planning. It is, however, often used in the feasibility study stage of public sector projects.
Undertaking planning and feasibility studies
During the planning phase of a public-sector project, the full public costs and benefits associated with the project must be evaluated. Alternatives need to be tested, including the option of ‘doing nothing’. The most favorable option would normally proceed only if it can be shown that the benefits exceed the costs.
Testing the feasibility of proposed projects includes an assessment of future uncertainties. Sensitivity analysis should be used to evaluate the range of possible scenarios in terms of demand and demographic changes, cost movements and the like.
Testing design alternatives
When a project is approved, the overall performance and cost parameters are set and the project is passed to a project team for implementation. Decisions made during the design process have a lasting and significant effect on the future life cycle performance of the asset.
Actions taken during this stage should include:
- Testing design alternatives, using life cycle planning - typical options to be tested include alternative layouts, surface coatings and treatments, heating, ventilation and air-conditioning (HVAC) configurations (some of which achieve low initial costs but incur high energy and maintenance costs) and major components such as roofing materials and floor coverings
- Injecting a ‘life cycle awareness’ into the design team by including the facilities manager in the team and insisting on preparation for maintenance during design (collecting data, installing maintenance systems etc.) and by being prepared to modify the capital cost limit if long-term life cycle cost benefits can be demonstrated.
Evaluating bids
If design-construct bids are being evaluated, operating cost components should be part of the bid. Life cycle costing is an appropriate technique to evaluate such bids.
Developing operations and maintenance strategies
Operating cost plans and budgets should be developed during the design stage in the same way as is done for a Capital Cost Plan. Life cycle costing techniques may be used to evaluate alternative methods of service delivery (e.g. using in house staff, contract labor, or outsourcing the entire task).
Assessing upgrades, enhancements, replacements
Proposals for enhancements, major repairs and refurbishment of assets occur during the operational phase of an asset. Life cycle costing should be used to assess the merits of these proposals, and to test alternatives in terms of both scope and timing.
Determining timing and method of disposal
Life cycle costing is the appropriate technique to assess the optimal timing for the disposal of an asset, and to assess alternative methods for the disposal. (Some of these methods may incur capital expenditure, such as that required to prepare the asset for sale.)
- The initial capital cost, including directly associated costs, such as fees and installation
- The expected total life (in years), before full replacement would become necessary. If this figure cannot be confidently assessed, use the design life of the facility as a whole
- The normal annual maintenance and operating cost of the building, using a ‘best practice’ preventive maintenance approach where appropriate. This should include an average cost for normal maintenance (e.g. cleaning, testing and inspections, lubrication, and routine replacement of small components such as fan belts), and be based on the appropriate number of operating hours and the maintenance standard required
- Expected times and costs, of major repairs, overhauls or refurbishments, scheduled on an annual basis
- A discount rate, to reflect the decreasing value of money, in today’s terms, as time passes
- The total life cycle cost of the asset (or ‘net present value’) is the sum of all annual expenditures for the expected life of the asset, but with the expenditure for each year discounted by the appropriate rate.
This exercise should be carried out for each significant option or choice, and the net present value of each compared. The lowest initial cost does not always correspond to the lowest life cycle cost.
Life cycle planning affords many benefits. In the first instance, it provides a framework for assessing and monitoring the effects of asset decisions in terms of ensuring that:
- Asset owners are aware of factors affecting asset life
- Adequate information is collected and appropriately managed to enable financial, functional and technical analyze to be made
- Appropriate financial and economic evaluation methods are used
- Sound and rigorously tested arguments can be mounted and considered in the decision-making process.
Secondly, the use of life cycle planning lifts the confidence of those making investment and management decisions about assets.
The routine use of the technique at the working level is also a valuable discipline for project teams and assists them to develop structured arguments for the analysis and assessment of alternatives.
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