HM TREASURY

Public Competition and Purchasing Unit

No. 35 Life Cycle Costing

This is one of a series of guidances prepared

by PCPU on purchasing and supply procedures
and practices. Its use is not mandatory but a
statement of good professional practice.
1

Departments should consider incorporating it

into their internal purchasing and supply
manuals.

INTRODUCTION

COST OF RELIABILITY FOR THE PRODUCER

1.1 Life Cycle Costing (LCC) is a technique to

establish the total cost of ownership. It is a structured
approach which addresses all the elements of this
cost and can be used to produce a spend profile of
the product over its anticipated life-span. The results
of an LCC analysis can be used to assist
management in the decision-making process when
there is a choice of product. The accuracy of LCC
analysis diminishes as it projects further into the
future, so it is most valuable as a comparative tool
when long term assumptions apply to all the options
and consequently have the same impact.
1.2 The principles of LCC can be applied not only
to complex items but also the simplest. For example,
the purchase of pencils might appear a
straightforward purchasing decision based on the
lowest price offered by a supplier provided the
quality requirement is met. However, the
requirement is not necessarily for pencils but a
need for a writing implement whose impression can
be erased. Therefore there are a number of options:
for example, propelling pencils with lead refills
which also incorporate an eraser, hence negating
the need for a separate purchase of them. The
options can be assessed using the principles of LCC
and the most cost-effective option for a writing
implement chosen. Although this may appear a
trivial example, it makes the point that LCC
principles apply to the majority of purchases.

cost

Reliability
FIGURE 1

1.3 For complex items, for example vehicles,

reliability is a major cost element for both producer
and consumer. Figure 1 shows how reliability affects
the cost of manufacturing by reducing scrap, rework
and warranty claims, and there is a level beyond
which the supplier sees no direct benefit in

improving the quality of the product. Figure 2

reflects the total cost of ownership with respect to
reliability, viewed from the consumers viewpoint.
This requires a considerable increase in reliability
beyond that justified by pure manufacturing costs.
1

Until industry understands that LCC means as much

to departments as does acquisition cost, they will not
invest in improving the reliability of the product
beyond the minimum manufacturing cost benefit.
COST OF RELIABILITY FOR THE CONSUMER

2.

SCOPE

2.1 This guidance introduces purchasing officials

and end users to the principles and practices of
LCC. Its methodology is applicable to most
purchasing decisions irrespective of complexity and
cost. It explains the implications of LCC and how and
where it should be applied, the methodology to use
and sufficient information for departments to produce
tailored instructions for incorporation into their own
departmental manuals.
3.

THE IMPLICATIONS OF LCC

3.1 The visible costs of any purchase represent

only a small proportion of the total cost of ownership.
Figure 3 gives a graphic representation using the
Iceberg Analogy and highlights the dangers of
poor financial management if only the apparent costs
are considered. Car fleet operators have for many
years evaluated total cost of ownership when
considering car purchases because running and
maintenance costs have a large impact on
profitability and have to be budgeted into their total
operation. In many departments, the responsibility
for acquisition cost and subsequent support funding
are held by different areas and, consequently, there
is little or no incentive to apply the principles of LCC
to purchasing policy. Therefore, the application of
LCC does have a management implication because
purchasing units are unlikely to apply the rigours of
LCC analysis unless they see the benefit resulting
from their efforts.

Reliability
FIGURE 2

Total Cost Visibility

THE ICEBERG EFFECT
ACQUISITION COST

SPECIAL TEST
EQUIPMENT COST

SUPPLY SUPPORT

FIGURE3

3.2 The cost of ownership of an asset is in fact

incurred throughout its whole life and does not all
occur at the point of acquisition. Figure 4 gives an
example of a spend profile showing how the costs
vary with time. In many instances the disposal cost
will be negative because the item will have a resale
value. However, for nuclear reactors the disposal
cost is extremely high and should be taken into
account at the planning stage.
3.3 A purchasing decision normally commits the
user to over 95 per cent of the through-life costs.
There is very little scope to change the cost of
ownership after the item has been delivered.

COST

cost-effectiveness of any warranty proposal.

Additionally, an incentive contract might be
negotiated to the benefit of the customer if the results
of an LCC analysis were available. The results allow
the purchaser to apply many more imaginative
contractual approaches to the benefit of the user.
4.4 For departments involved in the purchase of
items designed specifically to meet their
requirement, decisions in the design process should
be evaluated in terms of LCC. Trade-offs between
performance, cost and timescale involve many
complex and related parameters, eg material cost,
production rate, reliability and maintainability. It is
only through the use of LCC techniques that
meaningful trade-off decisions can be made. This
provides designers and managers with a systematic
approach to assessing the relevant design
parameters. It has been shown that the greatest
opportunity to reduce costs and improve
performance is during the initial development
phases. Funds spent during this time are relatively
small in comparison with total system life costs.
Nevertheless, decisions made at this time can have
profound cost implications on procurement,
operation and support costs.
4.5 LCC analysis should be used to evaluate
alternative support policies for items which require
maintenance. A major part of the support costs is
driven by design but there are other significant cost
drivers beyond the control of the supplier for
example:

TIME

TYPICAL COST PROFILE

FIGURE 4
4.

APPLICATION OF LCC ANALYSIS

4.1 The principles of LCC should be considered in

all purchasing decisions. It is important that the
specification should be presented in performance
terms rather than design detail. It should be
sufficiently tight so that the product or service fits the
users needs but not so explicit that it prevents
negotiation and discourages the supplier from using
expertise to propose innovation (see also guidance
no 30 Specification Writing). Often the supplier
knows more of the potential of the product than the
user.

-maintenance policy;
-training;
-training equipment;
-equipment deployment; and
-equipment utilisation.
These factors must be defined by the user prior to
the decision to purchase so that a full LCC analysis
can be undertaken.
5.

CONSTITUENTS OF LCC

5.1 In defining the cost of an item, account must be

taken of the following:
-purchase price;

4.2 Additionally, the purchaser of replacement

items should consider the LCC implications,
particularly where the users experience of
operating the product may be relevant. A bad
procurement decision in LCC terms should not be
compounded by the purchase of more of the same
purely through administrative inertia or for
convenience.

-staff costs including overheads;

4.3 For complex items the application of LCC

techniques can have a major impact on the
contractual negotiation process. For example, an
LCC analysis should be under-taken to establish the

-operating;

-training;
-training aids;
-support equipment - special tools, documentation
etc;
-transportation and handling;
-maintenance; and
-withdrawal from service and disposal

5.2 All of these costs can be broken down into

either one-off or recurring costs. One-off costs
include:
-purchase;
-installation and commissioning;
-initial training;
-documentation; and
-facilities.
Recurring costs normally include:
-retraining;
-operating costs;
-spares;
-maintenance and repair and
-transportation and handling.
It is important to appreciate the difference between
these cost groupings because one-off costs are sunk
once the acquisition is made whereas recurring
costs are time dependent and continue to be
incurred throughout the life of the product.
Furthermore, recurring costs can increase with time
if the equipment is liable to wear incurring
subsequent increased maintenance costs.
6.

THE METHODOLOGY OF LCC

-it must include all cost elements that are relevant

to the option under consideration;
-each cost element must be well defined so that all
involved have a clear understanding of what is to
be included in that element;
-each cost element should be identifiable with a
significant level of activity or major item of
hardware or software;
-the cost breakdown should be structured in such a
way as to allow analysis of specific areas. For
example, the purchaser might need to compare
spares costs for each option; these costs should
therefore be identified within the structure;
-the CBS should be compatible, through crossindexing, with the management accounting
procedures used in collecting costs. This will allow
costs to be fed directly to the LCC analysis;
-for programmes with subcontractors, these costs
should have separate cost categories to allow
close control and monitoring; and
-the CBS should be designed to allow different
levels of data within various cost categories. For
example, the analyst may wish to examine in
considerable detail the operator manpower cost
whilst only roughly estimating the maintenance
manpower contribution. The CBS should be
sufficiently flexible to allow cost allocation both
horizontally and vertically.

6.1 LCC is based on the premise that to arrive at

meaningful purchasing decisions full account must
be taken of each available option. All significant
expenditure of resources which is likely to arise as a
result of any decision must be addressed. Explicit
consideration must be given to all relevant costs for
each of the options from initial consideration through
to disposal.
6.2 The following fundamental concepts are
common to all applications of LCC:
-cost breakdown structure;

7
TOTAL COST

OPERATION

Equipment

OperatIonal

I
operator

Support Equipment

-cost estimating;
-discounting; and

6.3 CBS is central to LCC analysis. It will vary in

complexity depending on the purchasing decision.
Its aim is to identify all the relevant cost elements and
it must have well defined boundaries to avoid
omission or duplication. Figure 5 is an example of a
CBS for a major acquisition and consists of many cost
categories each with a variety of constituent parts.
This can be simplified for a minor purchase and
Figure 6 shows a CBS for such an item. However,
whatever the complexity any CBS should have the
following basic characteristics:

Management
manpower

Insurance
Fuel & Consumables

Documentations

-inflation.
Cost Breakdown Structure (CBS)

O P E R A T ION AND
MAINTENANCE

Utllltles R M a n a g e m e n t

Purchase

Management

Mamtenance

Set-up New Facllltles

Management

Mamtenance Manpower
I
SDTt-S

T r a n s p o r t R lnstallatlon

I
I

Commlsslonlng & T e s t

spares storage

Modlflcatlon

MAJOR PROJECT COST

BREAKDOWN STRUCTURE
FIGURE 5

Technical Guide for Government Departments - HM

Treasury 1991 ISBN 0 11 560034 5. The effect of
discounting on LCC analysis is at Figure 7. When
comparing two or more options, a common base is
necessary to ensure fair evaluation. As the present is
the most suitable time reference, all future costs must
be adjusted to their present value. Discounting refers
to the application of a selected discount rate such
that each future cost is adjusted to present time ie the
time when the decision is made. Discounting
reduces the impact of downstream savings and as
such acts as a disincentive to improving the
reliability of the product.

1T-
TOTAL COST

Purchase Cost

I
Initial

Training

Operator Manpower

I
Fuel

&Consumables

I
Training

Maintenance

Contract

MINOR PURCHASE COST

BREAKDOWN STRUCTURE

6.6 The procedure for discounting is

straightforward and discount rates for government
purchases are published. Discount rates used by
industry will vary considerably and care must be
taken when comparing LCC analyses which are
commercially prepared to ensure a common
discount rate is used.
Inflation
6.7 It is important not to confuse discounting and
inflation. The Discount Rate is not the inflation rate
but is the investment premium over and above
inflation. Provided inflation for all costs is
approximately equal, it is normal practice to exclude
inflation effects when undertaking LCC analysis.
A

FIGURE 6
Cost Estimating
6.4 Having produced a CBS, it is necessary to
calculate the costs of each category. These are
determined by one of the following methods:
-known factors or rates: are inputs to the LCC

analysis which have a known accuracy. For

example, if the Unit Production Cost (UPC) and
quantity are known, then the Procurement Cost
can be calculated. Equally, if staff costs and
equipment utilisation are known, then the Operator
Manpower Cost (OMC) can be calculated (ie staff
cost (per hour) x hours used per month = OMC);

Undiscounted Cost

-cost estimating relationships (CERs): are

derived from historical or empirical data. For

example, if experience had shown that for similar
items the cost of Initial Spares was 20 per cent of
the UPC, this could be used as a CER for the new
purchase. CERs can become very complex but, in
general, the simpler the relationship the more
effective the CER. The results produced by CERs
must be treated with caution as incorrect
relationships can lead to large LCC errors; and.

-expert opinion: although open to debate, it is

often the only method available when real data is

unobtainable. When expert opinion is used in an
LCC analysis it should include the assumptions
and rationale that support the opinion.

Discounting
6.5 Discounting relates to the value of money over
time. This guidance does not cover the topic in great
detail as it is a procedure common to many cost
appraisal methods and well understood by
purchasing officers. The subject is fully explained in
Economic Appraisal in Central Government: A

d
1

Life Cycle (years)

I

,
/

I
/

I
I

10

11

THE EFFECT OF DISCOUNTING ON THE

COST PROFILE
FIGURE 7

I
I

12 13

However, if the analysis is estimating the costs of two

very different commodities with differing inflation
rates, for example oil price and manhour rates, then
inflation would have to be considered. However, one
should be extremely careful to avoid double
counting of the effects of inflation. For example, a
vendors proposal may already include a provision
for inflation and, unless this is noted, there is a strong
possibility that an additional estimate for inflation
might be included.
7.

LCC BENEFITS

7.1

There are 4 major benefits of LCC analysis:

-evaluation of competing options in purchasing;

-improved awareness of total costs;
-more accurate forecasting of cost profiles; and
-performance trade-off against cost.
7.2 Option Evaluation. LCC techniques allow
evaluation of competing proposals on the basis of
through life costs. LCC analysis is relevant to most
equipment purchasing decisions from the simple to
the complex. Not only does the analysis allow for the
assessment of competing purchasing options but
also leasing. Equally, it can be used in market testing
procedures.
7.3 Improved Awareness. Application of LCC
techniques provides management with an improved
awareness of the factors that drive cost and the
resources required by the purchase. It is important
that the cost drivers are identified so that most
management effort is applied to the most costeffective areas of the purchase. Additionally,
awareness of the cost drivers will also highlight
areas in existing items which would benefit from
management involvement.
7.4 Improved Forecasting. The application of
LCC techniques allows the full cost of a purchase to
be estimated more accurately. It leads to improved
decision making at all levels, for example major
investment decisions, or the establishment of costeffective support policies. Additionally, LCC analysis
allows more accurate forecasting of future
expenditure to be applied to long-term costings
assessments.
7.5 Performance Trade-off Against Cost. In
many purchasing decisions cost is not the only factor
to be considered when assessing the options. For
example, the purchase of a photocopying machine
will be influenced by manufacturers claims for
reliability of their products. It is of no value having a
24 hour maintenance call-out contract if the
equipment fails every day. Equally, the availability of
the photocopier to a publication department is
probably far more crucial than to a general office.
LCC analysis allows for a cost trade-off to be made
against the varying attributes of the purchasing
options.

8.

LCC CONSTRAINTS

8.1 Data. It is normally relatively easy to establish

the acquisition cost of an item. It is far more difficult
to measure the operation and maintenance cost that
is likely to be incurred after purchase. Additionally,
much of the through life data, reliability for example,
will be provided by the manufacturer; this must be
treated with caution especially if it is not contractually
binding.
8.2 Resources. Undertaking an LCC analysis can
take considerable manpower resources. These can
be reduced by the use of proprietary LCC models,
but they are generally expensive and more complex
than needed for the majority of purchasing
decisions. Departments should therefore undertake
the analysis manually or consider producing simple
computer spreadsheets using relatively inexpensive
software packages to meet their LCC needs.
9.

CONCLUSION

9.1 The acquisition cost of a product can often

represent only a small proportion of the total cost of
ownership. Generally, operating and maintaining the
product will form the major part of the total cost.
However, purchasing decisions are normally made
on the acquisition price - the longer term costs being
ignored. True value for money can only be achieved
when the total cost of ownership is known. A worked
example is at Annex A.
April 1992

after adjusting for inflation) is used in the analysis

which gives the following discounting factors:

Annex
EXAMPLE OF AN LCC ANALYSIS
A department has a requirement for 50 photocopiers
capable of producing 40,000 copies per month from
each copier.
There are 2 copiers that fully meet the departments
technical specification together with the quality
requirements. The anticipated life of the copiers is 5
years.

Copier A Copier B
Metered cost/copy fixed in cash
terms for 5 years

10,745

8,625

0.9p

l.0p

Year 1

0.943

Year 2

0.890

Year 3

0.840

Year 4

0.792

The following example sets out the steps involved in

this procedure. All costs are expressed at year 0
prices. Staff costs and consumables will almost
certainly rise in line with inflation. But any costs
which will remain the same in cash terms over the
five years will need to be adjusted to year 0 prices
using a forecast of inflation which your finance
division will be able to give you. In this example,
inflation is assumed to be 4 per cent per year. It is
also assumed that the machines are deployed at
separate locations around the building not as part of
a continuous flow print room. In the case of the latter,
it would be necessary to allow for some standby
facility to maintain the required level of output.

The metered cost per copy offered by the suppliers

includes maintenance charges and all consumables.
The 2 proposals are as follows:
Unit Price for an order of 50

Year 0

To ascertain the most cost-effective acquisition in

through life cost terms an LCC analysis is carried
out. A Discount Rate of 6 per cent in real terms (ie

STEP 1 PRODUCE A COST BREAKDOWN STRUCTURE

/ TOTTCOST

1
OPERATION AND MAINTENANCE
COSTS

ACQUISITION

OPERATIONS

Purchase Costs

Operator Cost
I

Purchase Department
costs

Paper

On-going Training

Initial Operator
Training

- MAINTENANCE
Metred Cost/Copy
I

Operator Cost of
Un-Jamming

STEP 2: PRODUCE A COST ESTIMATE

Analysis

Acquisition

Copier A

Copier B

Purchase costs

537.25K 431.25K

Purchase department costs

(2 man/weeks)

2.5K

2.5K

(Operator training
time required per copier

3 hrs

2 hrs)

Total training cost

(2 operators per copier)
at 10 per hour x 50 copiers

3K

2K

542.75K

435.75K

Operator cost
Year 0
Year 1
Year 2
Year 3
Year 4

K
600
565.8
534.0
504.0
475.2

K
600
565.8
534.0
504.0
475.2

Paper (5 per 1000)

Year 0
Year 1
Year 2
Year 3
Year 4
On-going training

K
120
113.2
106.8
100.8
95.0
1.5

K
120
113.2
106.8
100.8
95.0
1

E3216.3

3215.8

Total acquisition cost

The example shows that the acquisition cost is far

exceeded by the maintenance costs. The cost of

operation although large is committed by the
decision to buy the copier and is not affected by the
choice. Therefore, it was unnecessary to discount
these costs as they apply equally to both options
The Maintenance Costs show the major cost drivers
over which the procurer has some control. Not only
are the meter costs important but also the time
expended by the operator in unjamming the
machine.

Operation (5 years)

Total operation cost

TOTAL TIME
With the following data:

Metered cost per copy

Adjusted at
Copier Copier
4%peryear
A
B
K

0.9p
1 .0p
Then discounted
at 6%

240.0 216.0
230.8
195.7
221.9
177.7
213.3
161.3
146.2
205.1
of un-jamming

176 hrs

176 hrs

Downtime for replacement of

consumables/month/copier
(company brochures)

3hrs

4hrs

Downtime for operator

un-jamming/month/copier
(user experience)

4hrs

13.3 hrs

5.4 hrs

10.8 hrs

Average downtime/month/copier 12.4 hrs 28.1 hrs

176 - 12.4 176 - 28.1
Uptime
=
Total time
176
176
Availability=
.
93%
84%

240.0
217.4
197.4
179.2
162.5

STEP 3: DRAW CONCLUSIONS

(source: previous experience)

5000

3000

Average down-time

0.5hr

lhr

5 year cost at lO/hour

Year 0
Year 1
Year 2
Year 3
Year 4

24
22.6
21.4
20.2
19.0

80
75.4
71.2
67.2
63.4

~1004.1

1353.7

4.831m

5.08Om

Total 5 year LCC

Copier B

Downtime for maintenance

engineers/month/copier
(expert opinion)

Mean number of copies between jamming

Total maintenance cost

Copier A
Total possible availability

Copier A Copier B

Maintenance (5 years)

Year 0
216.0
207.7
Year 1
199.7
Year 2
Year 3
192.0
Year 4
184.6
Operator/supervisor cost

Before the decision can be fully assessed the options

should be evaluated in performance terms. The
prime criterion for copiers of equal performance is
availability for use. This can be calculated as follows:
UPTIME
Availability =

Copier A although over 100,000 more expensive to

buy is some 349,OOO cheaper to own when
considered in LCC terms over 5 years (ie the
difference between the operation and maintenance
costs of copiers A and B). Additionally, Copier A
being a higher quality machine with better reliability
than Copier B is on average 9 per cent more
available than its competitor, or viewed alternatively,
Copier B would be unavailable for twice as long as
Copier A. The additional investment in purchase will
be more than recouped during the life of the copiers.