LIFE CYCLE COST DEFINITIONSLife cycle costs are summations of cost estimates from inception to disposal for both equipment and projects as determined by an analytical study and estimate of total costs experienced during their life. The objective of LCC analysis is to choose the most cost effective approach from a series of alternatives so the least long term cost of ownership is achieved. LCC analysis helps engineers justify equipment and process selection based on total costs rather than the initial purchase price. Usually the cost of operation, maintenance, and disposal costs exceed all other costs many times over. Life cycle costs are the total costs estimated to be incurred in the design, development, production, operation, maintenance, support, and final disposition of a major system over its anticipated useful life span (DOE 1995). The best balance among cost elements is achieved when the total LCC is minimized (Landers 1996). As with most engineering tools, LCC provides best results when both art and science are merged with good judgment.

What is Life Cycle Costing?

The Life Cycle Cost (LCC) of an asset is defined as:

“The total cost throughout its life including planning, design, acquisition and support costs and any other costs directly attributable to owning or using the asset". Life Cycle Costing adds all the costs of alternatives over their life period and enables an evaluation on a common basis for the period of interest (usually using discounted costs). This enables decisions on acquisition, maintenance, refurbishment or disposal to be made in the light of full cost implications.

Why use LCC

Procurement costs are widely used as the primary (and sometimes only) criteria for equipment or system selection. This single purpose criteria is simple to use but often results in bad financial decisions. Procurement costs tell only one part of the story—most frequently the story is so simple, the results may be damaging to the financial well-being of the business enterprise. Often the initial procurement costs, based on simple rules, are so cheap they are not affordable. Simple tools (meaning composed on only one thing) usually give simple results (meaning insubstantial, superficial, and not to be taken seriously). Remember the adage attributed to John Ruston: “It’s unwise to pay too much, but it’s foolish to spend too little”—this is the operating principle of LCC. End users and suppliers of equipment can use life-cycle costs for:

Affordability studies: Measure the impact of a system or project’s LCC on long term budgets and operating results.

Source selection studies:Compare estimated LCC among competing systems or suppliers of goods and services.

Design trade-offs: Influence design aspects of plants and equipment that directly impact LCC.

Repair level analysis:

Quantify maintenance demands and costs rather than using rules of thumb such as “…maintenance costs ought to be less than _ ? _% of the capital cost of the equipment”.

Warranty and repair costs:Suppliers of goods and services along with end-users need to understand the cost of early failures in equipment selection and use.

Suppliers sales strategies-can merge specific equipment grades with general operating experience and end-user failure rates using LCC to sell for best benefits rather than just selling on the attributes of low, first cost.

1.1 Why use Life Cycle Costing?The determination of costs is an integral part of the asset management process and is a common element of many of the asset manager’s tools, particularly Economic Appraisal, Financial Appraisal, Value Management, Risk Management and Demand Management.

In the past, comparisons of asset alternatives, whether at the concept or detailed design level, have been based mainly on initial capital costs. Growing pressure to achieve better outcomes from assets means that on-going operating and maintenance costs must be considered as they consume more resources over the asset’s service life. For example, the operating costs of a hospital consume an equivalent of the capital cost every two to three years and can continue to do so for forty years or more. The operating costs of a school can consume the equivalent of its capital cost every four to five years and remain in service for a century.

Both the capital and the ongoing operating and maintenance costs must be considered wherever asset management decisions involving costs are made. This is the Life Cycle Cost approach. Life Cycle Costing is a process to determine the sum of all the costs associated with an asset or part thereof, including acquisition, installation, operation, maintenance, and refurbishment and disposal costs. It is pivotal to the asset management process as an input to the evaluation of alternatives via

Economic Appraisal, Financial Appraisal, Value Management, Risk Management and demand management. There is an Australian Standard on Life Cycle Costing (AS4536) that includes examples of the application of Life Cycle Costing in its appendices.

Usuallythe only value in the life cycle cost equation which is well known and clearly identified is procurement cost—but it’s only the tip of the iceberg. Seeing the tip of an iceberg (similar to the obviousness of 3-5 Fifth International Conference on Process Plant Reliability procurement cost) does not guarantee clear and safe passage around an iceberg. Hidden, underlying, substructures of an iceberg (similar to the bulk of other costs associated with life cycle costing for equipment and systems) contain the hazards.

Life cycle cost

Life cycle cost is the total cost of ownership of machinery and equipment, including its cost of acquisition, research and development, operation, maintenance, conversion, and/or terminations

LCC costs have two major elements: 1) acquisition costs and 2) sustaining costs.

A& S cost are not mutually exclusive.. If you acquire equipment or processes, they always require extra cost to sustain the acquisition

A & S cost are found by evaluating the LCC and conducting the sensitivity analysis to find the cost drivers.

LCC concepts are resurging. LCC limitations are accepted as normal restrictions on every engineering tool. Usefulness has been demonstrated by passing the test of time with practitioners who have learned how to minimize LCC limitations. As with all cost techniques (and typical of all engineering tools) the limitations can result in substantial setbacks when judgment is not used. Here are some of the most often cited LCC limitations:

LCC is not an exact science, everyone gets different answers and the answers are neither wrong nor right—only reasonable or unreasonable. LCC experts do not exist because the subjects are too broad and too deep.

LCC outputs are only estimates and can never be more accurate that the inputs and the intervals used for the estimates—this is particularly true for cost-risk analysis.

LCC estimates lack accuracy. Errors in accuracy are difficult to measure as the variances obtained by statistical methods are often large.

LCC estimates lack accuracy. Errors in accuracy are difficult to measure as the variances obtained by statistical methods are often large.

LCC models operate with limited cost databases and the cost of acquiring data in the operating and support areas is both difficult to obtain and expensive to acquire.

LCC cost models must be calibrated to be highly useful.

LCC models require volumes of data and often only a few handfuls of data exist—and most of the available data is suspect.

Sunk costs

Sunk costs are sums that have already been spent and can not be recovered.

The concept is important because sunk costs are irrelevant to financial decisions. Many people tend to feel instinctively that because an investment has been made it is necessary to get a return on it. This can lead to people rejecting one course of action in favour of another that actually generates smaller cash flows. This can happen to business, portfolio investment and personal decisions.

Suppose a hotel has calculated that their cost for providing a room is £100 per night, of which £50 covers their rental of the building (i.e. the cost of the rental divided the number of rooms) and £20 covers their other fixed costs (such as staff) and £30 covers the costs that result from having an extra guest (e.g. electricity, laundry, food included in the price etc.)

Now suppose the market rate for hotel rooms goes down and they are only able to charge £50 per night. The hotel is committed to remaining open. It appears that the hotel will make a £50 loss on each night per guest so they should not accept bookings until prices rise. Of course this is wrong as the rent and other fixed costs are already committed to and have to be paid anyway. The hotel should accept bookings at any price it can get above £30, as these make a positive contribution.

A common mistake made by investors is reluctance to sell securities at a loss. It does not matter what you paid for shares, if the market price has fallen you have already made that loss. It is a sunk cost and should be forgotten about. What matters is whether the shares are worth holding or not at the current market price. A key question is whether the shares would still be worth buying at current prices. If not, they are probably not worth holding.

Sunk Costs:Sunk costs are costs that were incurred in the past. Committed costs are costs that will occur in the future, but that cannot be changed. As a practical matter, sunk costs and committed costs are equivalent with respect to their decision-relevance; neither is relevant with respect to any decision, because neither can be changed. Sometimes, accountants use the term “sunk costs” to encompass committed costs as well.

Experiments have been conducted that identify situations in which individuals, including professional managers, incorporate sunk costs in their decisions. One common example from business is that a manager will often continue to support a project that the manager initiated, long after any objective examination of the project seems to indicate that the best course of action is to abandon it. A possible explanation for why managers exhibit this behavior is that there may be negative repercussions to poor decisions, and the manager might prefer to attempt to make the project look successful, than to admit to a mistake. 

 Some of us seem inclined to consider sunk costs in many personal situations, even though economic theory is clear that it is irrational to do so. For example, if you have purchased a nonrefundable ticket to a concert, and you are feeling ill, you might attend the concert anyway because you do not want the ticket to go to waste. However, the money spent to buy the ticket is sunk, and the cost of the ticket is entirely irrelevant, whether it cost $5 or $100. The only relevant consideration is whether you would derive more pleasure from attending the concert or staying home on the evening of the concert.

Here is another example. Consider a student who is between her junior and senior year in college, deciding whether to complete her degree. From a financial point of view (ignoring nonfinancial factors) her situation is as follows. She has paid for three years of tuition. She can pay for one more year of tuition and earn her degree, or she can drop out of school. If her market value is greater with the degree than without the degree, then her decision should depend on the cost of tuition for next year and the opportunity cost of lost earnings related to one more year of school, on the one hand; and the increased earnings throughout her career that are made possible by having a college degree, on the other hand. In making this comparison, the tuition paid for her first three years is a sunk cost, and it is entirely irrelevant to her decision. In fact, consider three individuals who all face this same decision, but one paid $24,000 for three years of in-state tuition, one paid $48,000 for out-of-state tuition, and one paid nothing because she had a scholarship for three years. Now assume that the student who paid out-of-state tuition qualifies for in-state tuition for her last year, and the student who had the three-year scholarship now must pay in-state tuition for her last year. Although these three students have paid significantly different amounts for three years of college ($0, $24,000 and $48,000), all of those expenditures are sunk and irrelevant, and they all face exactly the same decision with respect to whether to attend one more year to complete their degrees. It would be wrong to reason that the student who paid $48,000 should be more likely to stay and finish, than the student who had the scholarship.    

Relevant costs Relevant costs are costs that change with respect to a particular decision. Sunk costs are never relevant. Future costs may or may not be relevant. If the future costs are going to be incurred regardless of the decision that is made, those costs are not relevant. Committed costs are future costs that are not relevant. Even if the future costs are not committed, if we anticipate incurring those costs regardless of the decision that we make, those costs are not relevant. The only costs that are relevant are those that differ as between the alternatives being considered. Including sunk costs in a decision can lead to a poor choice. However, including future irrelevant costs generally will not lead to a poor choice; it will only complicate the analysis. For example, if I am deciding whether to buy a Toyota Camry or a Subaru Legacy, and if my auto insurance will be the same no matter which car I buy, my consideration of insurance costs will not affect my decision, although it will slightly complicate the analysis.

Relevant costs A relevant cost is a cost that only relates to a specific management decision, and which will change in the future as the result of that decision.

The relevant cost concept is extremely useful for eliminating extraneous information from a particular decision-making process. Also, by eliminating irrelevant costs from a decision, management is prevented from focusing on information that might otherwise affect its decision.

For example, the Archaic Book Company (ABC) is considering purchasing a printing press for its medieval book division. If ABC buys the press, it will eliminate 10 scribes who have been copying the books by hand. The wages of these scribes are relevant costs, since they

will be eliminated in the future if management buys the printing press. However, the cost of corporate overhead is not a relevant cost, since it will not change as a result of this decision.

What is a differential cost?Differential cost is the difference between the cost of two alternative decisions, or of a change in output levels. Here are two examples:

Example of alternative decisions. If you have a decision to run a fully automated operation that produces 100,000 widgets per year at a cost of $1,200,000, or of using direct labor to manually produce the same number of widgets for $1,400,000, then the differential cost between the two alternatives is $200,000.

Example of change in output. A work center can produce 10,000 widgets for $29,000 or 15,000 widgets for $40,000. The differential cost of the additional 5,000 widgets is $11,000.

. In essence, you can line up the revenues and expenses from one decision next to similar information for the alternative decision, and the difference between all line items in the two columns is the differential cost.

A differential cost can be a variable cost, a fixed cost, or a mix of the two – there is no differentiation between these types of costs, since the emphasis is on the gross difference between the costs of the alternatives or change in output.

Since a differential cost is only used for management decision making, there is no accounting entry for it.