Life Cycle Cost Analysis

What is Life Cycle Cost (LCC) Analysis? A method of calculating the cost of a system over its entire life span.

Objectives of LCC Analysis

Evaluate the economic effectiveness of different mutually exclusive investment alternatives over a certain period Identify the most cost-effective alternative

Life Cycle Cost (LCC)

Life

cycle costing, LCC, is the process of economic analysis to asses the total cost of ownership of a product, including its cost of installation, operation, maintenance, conversion, and/or decommission.

Life Cycle Cost (LCC)

By

using LCC, total cost of the product can be calculated over the total span of product life cycle.

Life Cycle Cost (LCC)

LCC

is a economic tool which combines both engineering art and science to make logical business decision. This analysis provides important inputs in the decision making process in the product design, development and use.

LCC for product supplier

By

using LCC, product suppliers can optimize their design by evaluation of alternatives and by performing tradeoff studies. By using LCC, product suppliers can evaluate various operating and maintenance cost strategies (to assist product users).

LCC for customer

By

using LCC, customers can evaluate and compare alternative products. By using LCC, customers can assess economic viability of projects or products.

Why use LCC?

Typical conflict in most of the company:

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 operation hours as the only criteria, Reliability Engineering wants to nullify 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.

Why use LCC?

LCC

can be used as a management decision tool for synchronizing the divisional conflicts by focusing on facts, money, and time.

Why use LCC?

Why should engineers be concerned about cost elements? It is important for engineers to think like managers and act like engineers for a profit maximizing organization.

Money Does Matter!!!

Cost element

For an equipment, there are TWO cost elements:

1) Initial Cost, and 2) Operation & Maintenance Cost

The identification of cost elements and their sub-division are based on the purpose and scope of the LCC study.

Cost element

Initial Cost: Design & development cost, Investment on asset, or cost of equipment, Installation cost or erection & commission cost.

Cost element
Operation

& Maintenance Cost:

Labour cost, Energy cost, Spare & maintenance cost, Raw material cost.

Computation of Life Cycle Cost Analysis

(Steps for LCCA)

Steps for computation of LCC

Step 1: Determine time for each cost element, Step 2: Estimate value of each cost element, Step 3: Calculate Net Present Value of each element, for every year (over its time period), Step 4: Calculate LCC by adding all cost element, at every year, Step 5: Analyze the results.

Step 1: Determination of time

Determination of life cycle of the product (i.e. equipment, in this case).
This Life cycle is not similar to conventional concept of Product Life Cycle. Conventional concept of Product Life Cycle implies to the time span based on demand of the product in the market, starting from launch of the product up to the time when company withdraw the product from the market. That is purely a marketing concept.
To be continued

Step 1: Determination of time

In LCC analysis of an equipment, life cycle means the life of the product that is installed in the plant, i.e. productive life time of the product. The product supplier provides the life cycle depending on design calculation and experience. Based on suppliers data, customer decides the Life Cycle, i.e. how long he/ she wants to use the machine. Customer considers the effect of available maintenance facility, technological obsolescence and economic uncertainty factor, also.
To be continued

Step 1: Determination of time

After that, company decides the time span for each component. Example, say, a company decides that total life cycle of the product will be 10 years from the allocation the fund, among which first one year will be initial cost zone and remaining 9 years will be under operation and maintenance cost zone.

Step 2: Estimation of value

Estimate monetary value for each cost element. This estimated value will be incurred in every year. This value is basically future income at each year, which is estimated. To estimate the value, various source can be used; e.g. calculation based on facts and experience, MIS report for similar existing machines, etc.

Step 3: Net Present Value

Money has a time value. The present value of future income or future cost can be calculated by using discounting factor and inflation factor.

To be continued

Step 3: Net Present Value

Discount

factor

The discount rate is an interest rate, a central bank charges depository institutions that borrow reserves from it.
For example, let's say Mr. Ram expects Rs. 1,000 in one year's time. To determine the present value of this Rs. 1,000 Ram would need to discount it by a particular rate of interest (often the risk-free rate but not always). Assuming a discount rate of 10%, the Rs. 1,000 in a year's time would be equivalent of Rs. 909.09 to Ram today (i.e. 1000/[1+0.10]). To be continued

Step 3: Net Present Value

Inflation

factor

The inflation rate is the percentage by which prices of goods and services rise beyond their average levels. It is the rate by which the purchasing power of the people in a particular geography has declined in a specified period.

To be continued

Step 3: Net Present Value

Formula for Net Present Value (NPV)

C (1+i/100) (n-1) PV= ----------------------(1+d/100) n where, C = any cost element at nth year I = inflation rate d = discount rate/ interest rate

Step 4: Summation of PVs

PVs of each cost elements is calculated for an equipment (at every year). PVs of each cost element in a year are added. The process is done for every year over the life cycle, i.e. LCC is calculated for every year.

Step 5: Analysis
The datas collected from LCC are analyzed. If one product has to be selected among multiple equipments, then LCC is calculated for every product. Datas for every product are analyzed, and the lowest LCC option become preferred. But lowest LCC option may not necessarily be implemented when other considerations such as risk, available budgets, political and environmental concerns are taken into account.

An important reminder..
LCC provides critical information to the overall decision-making process, but not the final answer.

Backflush Costing

Backflush Costing

Backflush costing describes a costing system that omits recording some or all of the journal entries relating to the cycle from purchase of direct materials to the sale of finished goods.

Backflush Costing

Where journal entries for one or more stages in the cycle are omitted, the journal entries for a subsequent stage use normal or standard costs to work backward to flush out the costs in the cycle for which journal entries were not made.

A product costing system generally used in a just-in-time inventory environment. Backflush costing delays the costing process until the production of goods is completed. Costs are then flushed back at the end of the production run and assigned to the goods. This eliminates the detailed tracking of costs throughout the production process, which is a feature of traditional costing systems.

Contd..

By eliminating work-in-process accounts, backflush costing simplifies the accounting process. However, this simplification and other deviations from traditional costing systems mean that backflush costing may not always conform to generally accepted accounting principles (GAAP). Another drawback of this system is the lack of a sequential audit trail.