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There are many financial tools which help management to manager a project. On the background of management of the cost of project over time, it is important to consider the life cycle cost management method. This document is to explain about the life cycle cost management, the understanding about this financial tool and also provides the instruction to employ this method in management decision making. In detail, the processes that apply to life cycle cost management and the use of value engineering in life cycle cost management with practicals examples are provided.
Project, project management and project cost management
In the "a guide to the project management body of knowledge", "a project is a temporary endeavor undertaken to create a unique product or service" (PMOBK Guide, 2000, p.4). This definition established that every project has a definite beginning and definite end. Moreover, the product or service which the project conducts is different in some distinguishing way with all others products or services. Similarly, Gido and Clements stated that "a project is an endeavour to accomplish a specific objective through a unique set of interrelated tasks and the effective utilisation of resources."
Project management is defined by the PMBOK as "...the application of knowledge, skills, tools and techniques to project activities in order to meet stakeholder's needs and expectations from a project." (PMOBK Guide, 2000, p.6) In other words the project manager must do whatever is required to make the project happen.
Project cost management
Project cost management is one of the nine areas in project management knowledge, including four necessary processes, resource planning, cost estimating, cost budgeting and cost control that are required in order to accomplish the project within the approved budget (PMOBK Guide, 2000, p.83). The PMOBK notified that in the project, especially small ones, resource planning, cost estimating and cost budgeting are seem to be a single process but it is still important to split them because the tools and techniques for each are different (PMOBK Guide, 2000, p.85). Talking about the usefulness of cost management, cost management helps managers plan and control expenditures of projects by providing better information on time and where costs occur and what costs add to the value of a product (Babad & Balachandran, 1993).
Life cycle cost management
What is life cycle cost and life cycle cost management?
Life cycle cost (LCC) is identified as the total cost associated with the deployment of products during their economic life; all the costs which occurred during the design, development, installation, operation, maintenance and disposal of products will be covered (Barringer and Weber, 1996). In other words, life cycle cost (LCC) is a methodology that can assist cost management efforts by calculating the total cost of owning an asset in regard to the time value of money, it includes the cost to not only acquire the asset, but also to use, maintain, rehabilitate, and replace it (Bruce & William, 1980). In fact, from pre-operations to the end of the alternative in the life cycle cost, the costs for operation, maintenance and disposal far exceed the installation costs.
In businesses, analysts must execute LCC results in net present value (NPV) format with the consideration to depreciation, taxes and the time value of money. With the case of government, the inclusion of depreciation or taxes for LCC decisions is not required, but the time value of money is an essential element. (Barringer & Associates, 2003)
Overall, life-cycle costs (LCC) are all the costs about a project throughout the project's life; it includes all the costs from pre-operations to operations or to the end of the alternative. As the result, life cycle cost management is an economic model which is about to evaluate all the cost over the entire life of product or program effectively. Otherwise, LCC is used as a decision support tool, life cost management aims to choose the most cost-effective product that optimizes the total cost of its deployment, achieve the lowest long term cost of ownership (Barringer and Weber, 1996).
1.2 Life cost analysis
By life cost analysis, the creation, operation and disposal costs of a selected alternative are monitored throughout its life to enable accurate and timely decision-making as to how these costs can be minimised. Each owner is accountable for decisions required during the period of ownership only when ownership of the asset changes over time.
Life Cost Analysis is used as the basis for monitoring and management of costs over an asset's life. It is essentially a financial management tool costs which are generally not expressed as real or discounted costs but as nominal costs (ie. estimated costs that are to be paid when due) to enable a comparison of the predicted cost and the actual cost. This enables better prediction and adjustment of the Life Cycle Costing model (LCC).
Reasons of using life cycle cost
Generally, the evaluation of costs is an essential part of the asset management process, and it is also a general element of asset manager's tools such as Economic Appraisal, Financial Appraisal, Value Management, Risk Management and Demand Management. To achieve better outcomes from assets, the ongoing operating and maintenance costs must be considered as they consume more resources over the asset's service life; this is the Life Cycle Cost approach, a process which includes all the costs associated with an asset (New South Wales Treasury, 2004). Thus, the use of life cycle cost is vital, and 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. (New south wales Treasury, 2004).
Specifically, in regard to the purpose of minimise total costs of project and consider the conflicts observed in most companies:
Project Engineering wants to minimize capital costs as the only criteria,
Maintenance Engineering wants to minimize repair hours as the only criteria,
Production wants to maximize uptime hours as the only criteria,
Reliability Engineering wants to avoid failures as the only criteria,
Accounting wants to maximize project net present value as the only criteria.
Shareholders want to increase stockholder wealth as the only criteria.
Management needs to consider these above factors and the banner of minimise the cost of ownership, thus, LCC is a useful method with the role of a management decision tool by focusing on facts, money, and time. (Barringer & Associates, 2003)
Purposes of using life cycle cost and general using of life cycle cost management
As a decision support tool, the major purposes of using life cycle cost are economic appraisals and financial appraisals (Ã-zkil, n.d).
Economic appraisals are usually concerned by organisations or government bodies. In this case, the purpose of using LCC is to lead organisation or government bodies to be "well being". Basically, all the associated and necessary costs over the product's life are listed and calculated. However, the costs, which significantly affect the organisation's budget, are concerned precisely; any common costs not impacting the decision or simply transfer payments may be excluded to simplify, and hence reduce the total costs. (Ã-zkil, n.d)
In contrast to economic appraisals, financial appraisals generally include all the cash flows and transfer payments which occur in the entire life of projects (Ã-zkil, n.d)
Applying life cycle cost management
In applying life cycle cost, LCC is used as a decision and optimization criterion to seek the best negotiation between time, cost and performance. "LCC must be used as a benchmark against which options can be measured for 'value for money' during the acquisition process, bearing in mind that the greatest opportunities to reduce LCC usually occur during the early phases of the programme" (Ã-zkil, n.d).
2.1 LCC Models' characteristics
Before selecting a model of life cycle costing, the purpose of analysis and the required information should be identified in regard to some respect such as the applicability of costs, empirical relationship, constant and variable components.
Life cycle costing model is an accounting model which is available to estimate the total costs of from the beginning to the end of a product or program by a number of tools and factors in regard to the fact, money and time. In some specific case, some specific LCC models will be applied. Otherwise, in general, life cycle costing models should be:
â€¢ represent the characteristics of the asset being analysed including its intended use environment, maintenance concept, operating and maintenance support scenarios and any constraints or limitations
â€¢ be comprehensive enough to include and highlight the factors relevant to the asset LCC
â€¢ be easily understood to allow timely decision- making, future updates and modification
â€¢ be provided for the evaluation of specific LCC elements independently of other elements.
(New south wales Treasury, 2004)
2.2 LCC breakdown into asset cost elements
To apply the LCC model for a project, it is necessary to breakdown the project in to the cost elements. The level of costs breaking down depends on the requirement of project or LCC study. However, in all the case, the significant costs which generate the activities of project, the major resource cost categories such as labour, materials, overhead, energy etc., the time in which the activities in the life cycle is to be performed , are compulsory to be provided in the fixed or variable terms of costs.
(New south wales Treasury, 2004)
2.3 Sources of cost data
Sometimes much of information needed to derive accurate time and cost estimate is not available in the initial phase of the project-for example, design is not finalised (Gray & Larson, 2006).
In the case of employing new technology, the data is only can be based on the estimated unit cost parameters such as $/construction or construction unit/labour hours. During the life of the project, the data of cost will be more evident and sufficient (New south wales Treasury, 2004).
2.4 Methods of CLL analyses
There are several methods to analyse the CLL of a project. The particular method using depends on the amount of data which is about expected asset life and understanding about the technology employed in the asset.
These following methods are generally should be used:
â€¢ Analogous cost method
Analogous cost method involves cost estimation based on past experience with a similar project, product or technology (ÄŒápová, Kremlová & Schneiderová, 2004).
â€¢ Parametric cost method
Parametric cost method estimates the costs by considering major parameters and variances in the form of mathematical model. A parameter reflects a alteration factor from one system of units to another. An example of an empirical factor which may be obtained as a statistical average is the number of maintenance person-hours per failure of a given component. (ÄŒápová, Kremlová & Schneiderová, 2004).
â€¢ Engineering cost method
Engineering cost method involves direct estimation of a particular cost element by examining the product part by part. It uses standard budget items, or, for example, firm engineering and manufacturing estimates to develop the cost of each component and its relationship to other elements which is known as Cost Element Relationships - CER). (ÄŒápová, Kremlová & Schneiderová, 2004).
Life cycle costing together with Value engineering techniques are used to reduce cost and time, improve quality and performance, and optimise the decision-making. (PMOBK Guide, 2000, p.83)
The process of life cycle cost management
The figure above show five main steps of applying the life cycle cost management from left to right over the project's life cycle, from defining the problem to developing the estimate and analysing the results
The process of applying life cycle cost management can be more specific depends on the analyst in regard to a successful LCC application which when the evaluation can identify potential problems or impacts, influence decision making, and support future strategic planning and budgeting. (Chapter 23: life-cycle cost estimate, n.d)
According to Humphreys (2005), value engineering (VE) is a rational or scientific method to maximizing value by attempting to minimize direct costs and eliminate overdesigning while providing serviceability, safety, and favourable returns. In other way, VE is a technique directed toward analyzing the functions of an item or process to determine "best value," or the best relationship between worth and cost.
Dinsmore (1993) also states that "Value engineering provides project managers with a powerful tool for maintaining quality standards while eliminating unnecessary costs and giving visibility for cost reduction efforts in the event of cost growth" (p.197).
In brief, value engineering is an organized approach for obtaining optimal value for each dollar spent, while maintaining or improving quality, safety, reliability, and maintainability (Mansour & Fam, 1994). VE is a problem-solving technique based on analysis of the project functions demanded by the owners for the purpose of satisfying the end users. It makes the best of multi-discipline teams to analyze a product design, an engineering concept, or construction approach.
Value Engineering is not aimed at finding fault with current designs or ways to "cheapen" projects. Value Engineering is a process that looks at ways to:
Improve the overall design;
Simplify project construction;
Improve project maintenance and
Lower a project's initial and /or life-cycle cost.
In this part, the example is about the purchase of an automobile and it' LCC and value engineering are analyzed based on assumed information (Chapter 23: Life cycle cost estimating, n.d).
Step 1: Define the problem or scope
A buyer wants to purchase an automobile and has sufficient funds to purchase an automobile up to $25,000.
Definitive features are miles per gallon, estimated salvage value, costs of licenses and inspections, insurance, and estimated maintenance costs.
Step 2: Assumption or the requirements of the cost model being used should be defined
All money is spent at the end of a year for a given year
Buyer will trade the car in after four years
All models use the same grade of gasoline at $1.25 per gallon
The user drives 22,000 miles per year
Discount rate is 10 percent
Prices escalate 4 percent per year
Insurance cost escalate 3 percent per year
Salvage value is in dollars at the time of salvage
Step 3: Collecting data
Car A: Purchase price of the car is $17,000, fuel is 24 miles per gallon recommended maintenance is every 5,000 miles or 3 months, the average maintenance cost is estimated to be $250, and salvage value is $8,000.
Car C: Purchase price of the car is $13,000, fuel is 15 miles per gallon, recommended maintenance is every 10,000 miles or 6 months, the average maintenance cost is estimated to be $350 and salvage value is $5,000, initial cost of $800 is estimated to remedy some problems.
From this LCC analysis, Car C is more economical for the buyer than car A. From this simplified LCC analysis its benefits and purpose can be recognized.
Supporting calculations for annual costs:
For converting the future values to present worth, uniform capital recovery (UCR) factor will be applied. Using 10 percent rates, the UCR for the years 2,3, and 4 are as follows.
22,000 miles per year x 4 years = 88,000 miles
Car A: 88,000 miles/5,000 miles per maintenance = 117.6 (use 17 maintenance visit since the last one will be at the end of ownership)
This equates to 4.25 maintenance visits per year.
Car C : 88,000 miles / 10,000 miles per maintenance = 8.8 (use 8 maintenance visits since the last one will be at the end of ownership).
The equates to 2 maintenance visits per year of ownership
Based on the above information analyzed, the LCC and value engineering technique are shown their important role in helping to choose the best alternatives.
In conclusion, life cycle cost management and the use of value engineering in life cycle cost management is a useful technical to help the manager in decision making in finance in a long term business. This paper provided the instruction to apply the LCC in management and also a practical example to help the reader. There are some disadvantages when conducting LCC such as the sufficient of required data input, the knowledge of analyst about the project but the total project cost will be extremely evident by applying this method, especially with the value engineering in order to make an effective decision of a "well-being" company or organisation.