The History Of The Life Cycle Costing Accounting Essay

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Capital goods are machines or products that are used by manufacturers to produce their end-products or by service organizations to deliver their services. E.g. power generators, medical equipment used by hospitals to diagnose and treat patients, trains used by a service organization such as Virgin Trains to transport customers to their destinations. Capital goods are one of the most important parts of a company or organization's assets. They can be used for their usable life to produce the products or services for the customers and increase the value. It is the interest of both the manufacturer/supplier and customer/user to have a full understanding of the capital good life cycle and its associated costs.

It is widely believed that there are several life cycle models in industry to consider and most of them are rather similar. Fig. 2.1 shows one general life cycle model:

Fig. 2.1 A General Life Cycle Model (Source: http://www.ugs.com/)

Phase 1 Conceive: The life cycle starts with the definition of the capital good based on customers' requirements.

Phase 2 Design: This phase consists of detailed design and development of the capital good, prototype testing, pilot release and full product launch. It can also involve redesign and improvement to existing capital good.

Phase 3 Realize: Once the design of the capital good is complete the method of manufacturing is defined.

Phase 4 Service: The final phase of the life cycle involves managing of in service information, providing customers and service engineers with support information for repair and maintenance. Finally, there is an end-of-life to the capital good. It needs to be considered whether it is disposal or destruction of material.

One of the most remarkable things about life cycle is that life cycle process is iterative (Fig. 2.2). It is always possible that something doesn't work well in any phase enough to back up into a prior phase.

Fig. 2.2 The iteration characteristic of life cycle process (Source: http://www.ugs.com/)

Another life cycle model is developed by Kumar, et al. (2000), which consists of 5 phases (Fig. 2.3). In the first phase, needs and requirements are defined based on feedback from the customers and knowledge of technical possibilities. From the specifications of the capital good major technical parameters can be defined. Next, the system is completely designed. After that, multiple units of the system are produced. Then, in the exploitation phase, the capital good/system is used, generally for extended periods (10-40 years). Finally, the capital good/system is disposed of.

Fig. 2.3 Life cycle of a capital good (Kumar, et al., 2000)

To determine the costs associated with the different phases, Life Cycle Costing (LCC) analysis can be a very useful tool.

2.2 Life Cycle Costing

LCC analysis was firstly introduced and developed by the U.S. Department of Defense in order to minimize the expenses of their purchased equipment. Nowadays the concept is widely used in both private and public sectors as well as in different capital goods industries. In Fig. 2.4 a typical example is given on the costs distribution associated with the different phases of the capital good life cycle.

Fig. 2.4 Costs distribution of the capital good life cycle

To be brief, Life Cycle Costing (LCC) is a methodology for evaluating assets that takes into consideration all costs arising from owning, operating, maintaining, and disposing of the asset (Fuller and Peterson, 1996). It is the total discounted cost of acquisition, operation, maintenance and disposal of an asset or system over a fixed period of time. The elements of cost will be added together to give the total cost for each item and a grand total for the asset through its life time on a common basis for the period of interest. LCC analysis enables decisions on acquisition, maintenance, refurbishment or disposal of the asset to be made in the light of full cost implications. Following are two decompositions of costs from different perspectives.

From the perspective of customers, they are most interested in the Total Cost of Ownership (TCO). The Total Cost of Ownership (TCO) is the summation of the cost of acquiring and owning or converting an item of material, piece of equipment, or service and post-ownership cost, including the disposal of hazardous and other manufacturing waste. It also includes the cost of lost revenue as a result of downtime or interruption of service or end product. Therefore, under the traditional contract (without the performance-based logistics or power by the hour contract):

TCO = C acquisition + C maintenance + C downtime + C disposal (2.1)

Acquisition costs: It is the costs during the first three phases of the capital good life cycle (Fig. 2.3), namely, the initial cost incurred prior to putting the system into service which in many cases is high. It reflected in the sales price for new systems.

The rest of the TCO occurs after the purchase phase. Multiple types of costs arise during the exploitation phase, with maintenance and downtime accounting for the largest proportion. Maintenance costs consist of all the resources needed for maintenance, which may be executed by the customer or by the manufacturer or a third party. In any case, the items that have to be paid for include spare parts, service/maintenance engineers, infrastructure and management. Downtime costs may consist of direct costs, such as those caused by a reduction in the output of a factory, and indirect costs, such as those caused by loss of reputation and resulting loss of future revenues.

Finally, in the disposal phase, there will be disposal costs. Disposal cost is the cost or gain of getting rid of assets after use. These may be significant if systems contain environmentally unfriendly materials. In many cases, the disposal costs are low. While in some cases, systems or parts of systems may be refurbished and can be reused, so that disposal may even lead to revenue instead of cost.

To give an impression of how high the costs of a capital good may be after purchase, Fig. 2.5 shows how the TCO of an engineer-to-order system is divided over the acquisition, maintenance and downtime costs (Ã-ner et al., 2007).

Fig. 2.5 the TCO of an engineer-to-order system

The results showed that the amount of down time costs can account up to 48% of total LCC while maintenance cost account for 27%. For other systems, we may get different numbers, but generally the trend is the same: the acquisition costs account for only a fraction of the TCO. The maintenance and downtime costs accounted for a significant proportion. When the customers buy a new system, they are implicitly making further investments that are 2-4 times as great as the acquisition costs. Therefore, it is of interest of both original equipment manufacturers (OEM) and their customers to minimize the TCO.

Another decomposition of costs is given by El-Haram and Horner (2003). According to their study, Life cycle costing is composed of total acquisition cost, total facility management (operation and support) costs, and total disposal cost:

CT = C acquisition + C facility management + C disposal (2.2)

Facility Management Costs: Under LCC analysis, facility management (operation and maintenance) costs are future expenses which are similar to the maintenance and downtime costs. Facility management costs may be two to three times higher than acquisition costs. Thus, there is a need to design projects that minimizes facility management costs.

2.3 The Life Cycle Costing Process

Life Cycle Costing is a six-staged process as show in Fig. 2.6:

Fig. 2.6 Life Cycle Costing process (Life Cycle Costing guideline, 2004)

Stage 1 Plan LCC analysis

The Life Cycle Costing process begins with the development of a plan, which addresses the purpose and scope of the analysis. The plan should:

Define the analysis objectives in terms of performance required to assist management decisions.

Describe the scope of the analysis considering the lifetime of the capital goods/assets, the operating environment and the maintenance support resources to be employed etc.

Identify any underlying conditions, assumptions, limitations and constraints (such as minimum asset performance, availability requirements or maximum capital cost limitations) that might restrict the range of acceptable options to be evaluated.

Provide an estimate of resources required and a reporting schedule for the analysis to ensure that the LCC results will be available to support the decision-making process.

The plan should be documented at the beginning of the Life Cycle Costing process to provide a focus for the rest of the work. Thus the customers/users can review the plan to ensure their requirements have been correctly interpreted and clearly addressed.

Stage 2 Select/develop LCC model

Stage 2 is the selection or development of a LCC model that satisfies the objectives of the analysis.

LCC model contains terms and factors which enable estimation of all relevant component costs. Before selecting a model, the purpose of the analysis and the information it requires should be identified. The model should also be reviewed with respect to the applicability of all cost elements, empirical relationships, constants and variables.

A number of available models can be used for LCC analysis. And in some cases it is appropriate to develop a specific model. In either case, the LCC model should:

Construct a cost breakdown structure (CBS) that identifies all relevant cost categories in all appropriate life cycle phases. Cost categories should continue to be broken down until a cost can be readily estimated for each individual cost element.

Identify the cost elements that won't have significant impacts on the overall LCC of the capital goods/assets. These elements may be eliminated from further consideration.

Make appropriate assumptions which should be documented to guide and support the subsequent phases of the analysis process.

Select a method for estimating the cost associated with each cost element to be included in the model.

Determine the data required to develop the estimates and identify sources for the data.

Identify uncertainties that are likely to be associated with the estimation of the cost elements.

Integrate the individual cost elements into a unified LCC model, which provides the LCC results required to meet the analysis objectives.

Stage 3 Apply LCC model

Application of the LCC Model involves the following steps:

Obtain data and develop cost estimates and their timing for all the basic cost elements in the LCC model.

Identify cost drivers by examining LCC model inputs and outputs to determine the cost elements that have the most significant impact on the LCC of the capital goods/assets.

Validate the LCC model with available historical data if possible.

Summarize and categorize the LCC model outputs according to the logical groupings (e.g. fixed or variable costs, acquisition or ownership costs, direct or indirect costs).

Conduct sensitivity analyses to examine the impact of variations to assumptions and cost element uncertainties on LCC model results. Particular attention should be focused on cost drivers, assumptions related to asset usage and different discount rates.

Review LCC outputs against the objectives defined in the analysis plan stage to ensure that all goals have been fulfilled and that sufficient information has been provided to support the decision. If the objectives are not met, additional evaluations and modifications to the LCC model may be required.

Stage 4 Document and review LCC results

The results of the LCC analysis (including all assumptions) should be documented to ensure that the results can be verified and readily replicated by another analyst if necessary and allow the customers/users to clearly understand both the outputs and the implications of the analysis along with the limitations and uncertainties associated with the results. Also, a formal review of the analysis process may be required to confirm the integrity and accuracy of the results, conclusions and recommendations.

The report should contain the following basic contents:

Executive Summary: a brief synopsis of the objectives, results, conclusions and recommendations of the analysis.

Purpose and Scope: a statement of the analysis objective, asset description including a definition of intended asset use environment, operating and support scenarios, assumptions, constraints.

LCC Model Description: a summary of the LCC model, including relevant assumptions, the LCC cost elements and breakdown structure along with the methods of estimation and integration.

LCC Model Application: a presentation of the LCC model results including the identification of cost drivers, the results of sensitivity analyses and the output from any other related analyses.

Discussion: discussion and interpretation of the results including identification of uncertainties or other issues which will guide decision makers and users in understanding and using the results.

Conclusions and Recommendations: a presentation of conclusions related to the objectives of the analysis and a list of recommendations along with identification of any need for further work or revision of the analysis.

Stage 5 Prepare Life Cycle Costing Analysis

The Life Cycle Costing Analysis is essentially a tool, which can be used to control and manage the ongoing costs of the capital goods/assets. It is based on the LCC Model which was developed and applied during the previous stages with one important difference: it uses data on nominal costs.

The preparation of the Life Cycle Costing Analysis involves review and development of the LCC Model as a "real-time" cost control mechanism. This requires changing the costing basis from discounted to nominal costs. Estimates of capital costs will be replaced by the actual prices paid. Changes may also be required to the cost breakdown structure and cost elements to reflect the asset components to be monitored and the level of detail required.

Targets are set for the operating costs and their frequency of occurrence based initially on the estimates used in the previous stages. These targets may change with time as more accurate data is available, either from the actual asset operating costs or from benchmarking with other similar assets.

Stage 6 Implement and monitor Life Cycle Costing analysis

Implementation of the LCC analysis involves the continuous monitoring of the actual performance of the capital good/asset during its operation and maintenance phases to identify areas in which cost savings may be made and to provide feedback for future life cycle costing planning activities.

2.4 Life Cycle Costing Model

An appropriate LCC model is provided in Fig. 2.7 by Woodward (1997). The model shows in the first step the cost elements of interest are defined from the perspective of manufacturer/supplier and of the customer/user. The second step defines the cost structure to be used, which will result in the potential trade-off relationships. The next step is to determine the mathematical relationship between the costs. The fourth step is to establish a methodology to evaluate the trade-off points of LCC considering all the relationships and uncertainty. Finally we get the LCC analysis results.

Fig. 2.7 the LCC analysis model (Woodward, 1997)

2.4.1 Cost elements

Estimating the total LCC requires breakdown of the capital good/asset into its constituent cost elements over time. The level to which it is broken down will depend on the purpose and scope of the LCC study and requires identification of:

significant cost generating activity components

the time in the life cycle when the work/activity is to be performed

Relevant resource cost categories (e.g. labour, materials, fuel/energy)

Woodward (1997) identified the following important cost elements when conducting the LCC analysis:

Acquisition costs

Life of the product or system

Discount rate and inflation

Operating and Maintenance costs

Disposal cost

Information and feedback

Uncertainty and sensitivity analysis

For the last two points: Information and feedback is required to test whether the LCC calculations are accurate; the uncertainty takes different inflation and discounting scenarios into account; the sensitivity analysis measures the performance variations and design alternatives. For instance, if a small change in a parameter results in a large change in outcome, the outcome is sensitive to that parameter.

Costs associated with LCC elements may be further allocated between recurring and non-recurring costs. LCC elements may also be estimated in terms of fixed and variable costs. To facilitate control and decision-making and to support the Life Cycle Costing process, the cost information should be collected and reported in a manner consistent with the defined LCC breakdown structure.

2.4.2 Cost breakdown structure

In order to conduct a LCC analysis it is necessary to create a structure that facilitates the identification of project costs in each of the life cycle phases. The British Standard 5760, part 23, has a cost breakdown structure (CBS) that identifies all relevant costs categories in all appropriate life cycle phases. The life cycle cost breakdown structure has five levels (Fig.2.8):

Fig. 2.8 LCC break-down structures

Level 1: The project level has four phases: design, production, facility management and disposal.

Level 2: The phase level break down the four phases into their respective cost categories, namely the design and development costs; the production and assembly costs; the operation, service, support and maintenance costs; and the removal and disposal costs.

Level 3: The category level takes each category and subdivides it into its cost elements. The design and development costs include the costs related to research and development, engineering design, development and tests, and design documentation. The production and assembly costs comprise manufacturing and assembly, facility construction, and initial logistic support costs. The operation, service, support and maintenance costs contain operations of the system in the field, keeping the system up to an acceptable standard through service and maintenance, and sustaining maintenance and logistic support throughout the system life cycle. Finally, the removal and disposal costs of the system are the estimated value of a system at the end of its expected life, including demolishing cost, recycling or reusing cost and salvation value (Blanchard et al., 1995; Kumar et al., 2000).

Level 4: The element level takes the categories from level 3 and breaks them down into their sub cost elements. For instance, the costs related to research and development can be disaggregated into the costs of personnel, data collection, historical information analysis and other elements. The cost of operation in the field costs can be broke down into the cost of electric, natural gas, water etc.

Level 5: The task level is the total cost of all the resources required to complete a task.

Fig. 2.9 shows a LCC breakdown structure based on Blanchard et al. (1995).

Life Cycle Costing (LCC)

Design

Production

Facility management

Disposal

Design and development

Production and assembly

Operations service and maintenance

Removal and disposal

Research &development

Manufacturing and assembly

Operations

Engineering design

Manufacturing engineering

Tools and test equipment

Fabrication

Inspection and test

Quality control material

Packing and shipping

Service and maintenance

System engineering

Electrical design

Mechanical design

Reliability

Maintainability

Human factors

Logistic support analysis

Maintenance/support personnel

Spare/repair parts

Test and support equipment

Transportation and handling

Maintenance/support training

Maintenance/support facilities

Maintenance management

Technical data

Computer resources

System downtime

Construction

Manufacturing facilities

Test facilities

Operational facilities

Maintenance facilities

Development and test

Engineering models

Test and evaluation

Design documentation

Initial logistic support

System modifications

Program management

Provisioning

Initial inventory management

Technical data preparation

Initial training

Training equipment

Test and support equipment

Fig. 2.9 LCC breakdown structure (based on Blanchard et al., 1995)

Estimating cost elements

The method used to estimate the cost elements in LCC calculations will depend on the amount of information available. By definition, detailed cost data will be limited in the early stages, particularly during the design/acquisition phase. Cost data during these early stages will need to be based on the cost performance of similar asset components currently in operation. Where new technology is being employed, data can only be based on estimated unit cost parameters specified or suggested by the technician. More information on the asset component costs will become available during the use of the capital good/asset, enabling more complete and descriptive costs to be defined.

2.4.4 The estimating cost relationships

The majority of the cost drivers are determined and locked up in the design phase. This phase determines the reliability, maintainability and the effectiveness of the system and its components. It is important to have a good understanding of how specified assets or systems will perform in the future.

Reliability is the probability that a product manufactured to a given design will operate throughout a specified period without experiencing a chargeable failure, when maintained in accordance with manufacturer's instructions and not subject to the environmental or operational stresses beyond limits stipulated by the manufacturer or set forth in the purchase agreement (Moss and Dekker, 1985).

Maintainability is that element of product design concerned with assuring that ability of the product to perform satisfactorily can be sustained throughout its intended useful life span with minimum expenditure of money and effort agreement (Moss and Dekker, 1985).

A system is technically available when it can meet the throughput where its customer agreed on. Availability of a system is typically measured as a factor of its reliability. The System Availability is the probability that a system will be in a condition to perform its intended function when. As widely recognized, the formula for system availability is:

System availability= (2.3)

In general it can be stated that LCC are largely determined by the system availability (A) requirements set by the customer:

LCC = C(A) acquisition + C(A)maintenance+ C(A) downtime+ Cdisposal (2.4)

A (2.5)

Where

MTBF: Mean-Time-Between-Failures and MTBF measures the system uptime

MDT: Mean-Down-Time and MDT measures the system downtime

The most important aspect of LCC in the design phase is the mean time between failures (MTBF) of the system. MTBF is defined as the average time before the first failure of a repairable system occurs (Kumar et al., 2000). On one hand MTBF plays an important role in the costs of the design phase, increasing the MTBF of the system will increase the system's acquisition cost (Ã-ner et al., 2008). On the other hand it also plays an essential role in the maintenance costs of the life cycle, namely, increasing the MTBF of the system will reduce the maintenance costs.

The other important aspect is the time the system is expected to be out of operation when a failure occurs. Although system's MTBF are quite long, the mean down time (MDT) determines the costs of not operating for each system failure. Therefore OEMs should make sure these down times are as low as possible.

The relationship between LCC and system availability is complex because changes in system availability can increase certain LCC components and lower others. Thus it means that there will be a trade-off point between the MTBF, MDT and the LCC. Elaborate discussions will be made in the following chapters.

2.5 Discounting and Inflation

Discounting and inflation are two important components which should be treated carefully when calculating the LCC.

Discounting is a method where the investment for a future period is adjusted to the time value of money by a discount rate. A discount rate is the percentage of difference between the value of an investment paid in the present and the value of an investment paid in the future. Also, in LCC analysis it is common to take into account inflation rates for the future period. In order to take some uncertainty into account different rates can be chosen. The associated discount rate should be used with care, since there are differences between real and nominal discount rates. The former excludes inflation and the latter includes inflation.

In business activities, discount rates are usually based on market interest rates, that is, nominal interest rates which include the investor's expectation or general inflation. Market interest rates generally serve as the basis for the selection of a nominal discount rate, which is used to discount future costs expressed in current dollars. In contrast, the real discount rate needed to discount constant dollar amounts to present value reflects only the real earning power of money, not the rate of general inflation (Fuller and Petersen, 1996). The real discount rate, d, can be derived from the nominal discount rate, D, if the rate of inflation, I, is known. The relationship is as follows:

(2.6)

Then the general formula for the LCC present-value model is:

(2.7)

Where

LCC= total LCC in present-value

Ct= sum of all relevant costs, including initial and future costs

N= number of years in the study period, and

d= real discount rate used to adjust cash flows to present value

Furthermore, the discount rate is likely to change from period to period and there are many discount rates. When using the real discount rate in present value calculations, cost should be expressed in constant dollars. Taxes and depreciation allowances should be accounted for in LCC calculations, as well as any local value effect. Generally, the straight-line method of depreciation is used. It is simple to use and it is based on the principle that each period of the asset life should depreciate equally (Ellis, 2007).

2.6 Conclusion

LCC analysis is used as the basis for monitoring and management of costs over the capital good or asset's life time. It is essentially a financial management tool. In practice, costs are generally not expressed as real or discounted costs but as nominal costs to enable a comparison of the predicted cost and the actual cost. This enables better prediction and adjustment of the Life Cycle Costing model.

In the article wrote by Ellis (2007), he stated that according to previous studies, previous LCC calculations did not produce reliable forecasts. The estimated values might be quite different from actual values and that attempting to estimate far in the future could lead to forecasting errors (Ashworth, 1996). And LCC is not an exact science, outputs are only estimates and estimates are not accurate. Even so, given robust and realistic assumptions, LCC analysis is a useful aid for the customers/users to compare life cycle cost of mutually exclusive assets and determine which asset provides the best value per unit money spent (Barringer and Weber, 1996). For the application of LCC analysis, realistic assumptions can be obtained from evaluating the performance of similar assets, conducting literature reviews, obtaining information from manufacturers, vendors, contractors, and using average support and maintenance costs (Robinson, 1996) and it should be performed early in the design phase.

The determination of costs is an integral part of the asset management process. LCC analysis can be applied to any capital investment decision in which higher initial costs are traded for reduced future expenses.

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