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 INTRODUCTION

Departments should consider incorporating it into their internal purchasing and supply manuals.

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. 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 1




improving the quality of the product. Figure 2 reflects the total cost of ownership with respect to reliability, viewed from the consumer’s viewpoint. This requires a considerable increase in reliability beyond that justified by pure manufacturing costs.

In many departments. Its methodology is applicable to most purchasing decisions irrespective of complexity and cost.1 This guidance introduces purchasing officials and end users to the principles and practices of LCC. the methodology to use and sufficient information for departments to produce tailored instructions for incorporation into their own departmental manuals. 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. 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. 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. consequently. Therefore. SCOPE 2.1 The visible costs of any purchase represent only a small proportion of the total cost of ownership. there is little or no incentive to apply the principles of LCC to purchasing policy. the responsibility for acquisition cost and subsequent support funding are held by different areas and. THE IMPLICATIONS OF LCC Reliability FIGURE 2 3. Total Cost Visibility THE ICEBERG EFFECT ACQUISITION COST SPECIAL TEST EQUIPMENT COST SUPPLY SUPPORT FIGURE3 . It explains the implications of LCC and how and where it should be applied.Until industry understands that LCC means as much to departments as does acquisition cost. 3. COST OF RELIABILITY FOR THE CONSUMER 2. they will not invest in improving the reliability of the product beyond the minimum manufacturing cost benefit.

5 LCC analysis should be used to evaluate alternative support policies for items which require maintenance. 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. APPLICATION OF LCC ANALYSIS -maintenance policy. for nuclear reactors the disposal cost is extremely high and should be taken into account at the planning stage. The results allow the purchaser to apply many more imaginative contractual approaches to the benefit of the user. These factors must be defined by the user prior to the decision to purchase so that a full LCC analysis can be undertaken. Figure 4 gives an example of a spend profile showing how the costs vary with time.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. 4. particularly where the user’s experience of operating the product may be relevant. 5. -training equipment.special tools. For example. cost-effectiveness of any warranty proposal. -training.1 The principles of LCC should be considered in all purchasing decisions. -operating. decisions in the design process should be evaluated in terms of LCC.4 For departments involved in the purchase of items designed specifically to meet their requirement. account must be taken of the following: -purchase price.3 For complex items the application of LCC techniques can have a major impact on the contractual negotiation process. 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: COST TIME TYPICAL COST PROFILE FIGURE 4 4. -training. -support equipment . This provides designers and managers with a systematic approach to assessing the relevant design parameters. It is important that the specification should be presented in performance terms rather than design detail. the purchaser of replacement items should consider the LCC implications.3. -equipment deployment. -staff costs including overheads. operation and support costs. It has been shown that the greatest opportunity to reduce costs and improve performance is during the initial development phases. 3. and -equipment utilisation. -transportation and handling. and -withdrawal from service and disposal . CONSTITUENTS OF LCC 4. It is only through the use of LCC techniques that meaningful trade-off decisions can be made. production rate. It should be sufficiently tight so that the product or service fits the user’s 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”). an incentive contract might be negotiated to the benefit of the customer if the results of an LCC analysis were available. In many instances the disposal cost will be negative because the item will have a resale value. 4.1 In defining the cost of an item. Nevertheless. -training aids. There is very little scope to change the cost of ownership after the item has been delivered. Often the supplier knows more of the potential of the product than the user. eg material cost. an LCC analysis should be under-taken to establish the 5. 4.2 Additionally. 4. Trade-offs between performance. Funds spent during this time are relatively small in comparison with total system life costs. documentation etc.3 A purchasing decision normally commits the user to over 95 per cent of the through-life costs. Additionally. However. decisions made at this time can have profound cost implications on procurement. reliability and maintainability. -maintenance. cost and timescale involve many complex and related parameters.

1 LCC is based on the premise that to arrive at meaningful purchasing decisions full account must be taken of each available option. This will allow costs to be fed directly to the LCC analysis. through crossindexing. -installation and commissioning. these costs should therefore be identified within the structure. -documentation. Furthermore. the analyst may wish to examine in considerable detail the operator manpower cost whilst only roughly estimating the maintenance manpower contribution. -operating costs.2 All of these costs can be broken down into either “one-off” or “recurring” costs. -each cost element must be well defined so that all involved have a clear understanding of what is to be included in that element. -for programmes with subcontractors. 6. 6. and -facilities. recurring costs can increase with time if the equipment is liable to wear incurring subsequent increased maintenance costs. the purchaser might need to compare spares costs for each option. and -the CBS should be designed to allow different levels of data within various cost categories.2 The following fundamental concepts are common to all applications of LCC: -cost breakdown structure. and -inflation. It will vary in complexity depending on the purchasing decision. For example.3 CBS is central to LCC analysis. -cost estimating. One-off costs include: -purchase. 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. The CBS should be sufficiently flexible to allow cost allocation both horizontally and vertically. For example. -initial training. -each cost element should be identifiable with a significant level of activity or major item of hardware or software. THE METHODOLOGY OF LCC -it must include all cost elements that are relevant to the option under consideration. -maintenance and repair and -transportation and handling. Explicit consideration must be given to all relevant costs for each of the options from initial consideration through to disposal. Recurring costs normally include: -retraining. All significant expenditure of resources which is likely to arise as a result of any decision must be addressed. -discounting. with the management accounting procedures used in collecting costs. However. -spares. these costs should have separate cost categories to allow close control and monitoring. Its aim is to identify all the relevant cost elements and it must have well defined boundaries to avoid omission or duplication. 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. 6. This can be simplified for a minor purchase and Figure 6 shows a CBS for such an item. -the cost breakdown should be structured in such a way as to allow analysis of specific areas. Cost Breakdown Structure (CBS) 6. whatever the complexity any CBS should have the following basic characteristics: Purchase Management Documentations Equipment Support Equipment 7 TOTAL COST O P E R A T ION AND MAINTENANCE OPERATION I i OperatIonal I operator I Management manpower Insurance Fuel & Consumables Utllltles R M a n a g e m e n t I Set-up New Facllltles T r a n s p o r t R lnstallatlon Commlsslonlng & T e s t Mamtenance Management I I I Mamtenance Manpower I SDTt-S spares storage Modlf’lcatlon I I MAJOR PROJECT COST BREAKDOWN STRUCTURE FIGURE 5 .5. -the CBS should be compatible.

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. 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. The effect of discounting on LCC analysis is at Figure 7. often the only method available when real data is unobtainable. and. a common base is necessary to ensure fair evaluation. then the Procurement Cost can be calculated. 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.HM Treasury 1991” ISBN 0 11 560034 5. -expert opinion: although open to debate. Undiscounted Cost I‘ -cost estimating relationships (CERs): are “3 derived from historical or empirical data. The subject is fully explained in “Economic Appraisal in Central Government: A d 1 2 3 4 5 6 7 . if the Unit Production Cost (UPC) and quantity are known. it is necessary to calculate the costs of each category. if staff costs and equipment utilisation are known. The results produced by CERs must be treated with caution as incorrect relationships can lead to large LCC errors. Equally. When comparing two or more options. A I Training Maintenance Contract MINOR PURCHASE COST BREAKDOWN STRUCTURE FIGURE 6 Cost Estimating 6.6 The procedure for discounting is straightforward and discount rates for government purchases are published.5 Discounting relates to the value of money over time. Inflation 6. all future costs must be adjusted to their present value.1T-’ TOTAL COST Purchase Cost I Initial Training Operator Manpower I Fuel &Consumables Technical Guide for Government Departments . Life Cycle (years) I . For example. I I . in general.7 It is important not to confuse discounting and inflation. 6. For example. The Discount Rate is not the inflation rate but is the investment “premium” over and above inflation. Discounting reduces the impact of downstream savings and as such acts as a disincentive to improving the reliability of the product. 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. the simpler the relationship the more effective the CER. / 8 I / 9 I I I I 10 11 12 13 I I THE EFFECT OF DISCOUNTING ON THE COST PROFILE FIGURE 7 5 . CERs can become very complex but. then the Operator Manpower Cost (OMC) can be calculated (ie staff cost (per hour) x hours used per month = OMC). When expert opinion is used in an LCC analysis it should include the assumptions and rationale that support the opinion. These are determined by one of the following methods: -known factors or rates: are inputs to the LCC analysis which have a known accuracy. it is Discounting 6. it is normal practice to exclude inflation effects when undertaking LCC analysis. As the present is the most suitable time reference.4 Having produced a CBS. Provided inflation for all costs is approximately equal.

the longer term costs being ignored. much of the through life data. if the analysis is estimating the costs of two very different commodities with differing inflation rates. 7. The application of LCC techniques allows the full cost of a purchase to be estimated more accurately.However. 9.2 Option Evaluation. or the establishment of costeffective support policies. it can be used in market testing procedures. a vendor’s proposal may already include a provision for inflation and. True value for money can only be achieved when the total cost of ownership is known. Additionally. operating and maintaining the product will form the major part of the total cost. for example major investment decisions.4 Improved Forecasting. unless this is noted. reliability for example.1 LCC BENEFITS There are 4 major benefits of LCC analysis: 8. but they are generally expensive and more complex than needed for the majority of purchasing decisions. one should be extremely careful to avoid double counting of the effects of inflation. LCC techniques allow evaluation of competing proposals on the basis of through life costs. However.2 Resources. LCC analysis allows for a cost trade-off to be made against the varying attributes of the purchasing options.3 Improved Awareness. It leads to improved decision making at all levels. for example oil price and manhour rates. 7. 8. awareness of the cost drivers will also highlight areas in existing items which would benefit from management involvement. LCC analysis is relevant to most equipment purchasing decisions from the simple to the complex. -improved awareness of total costs. will be provided by the manufacturer. Generally. For example. It is important that the cost drivers are identified so that most management effort is applied to the most costeffective areas of the purchase. there is a strong possibility that an additional estimate for inflation might be included. Not only does the analysis allow for the assessment of competing purchasing options but also leasing. April 1992 . 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 normally relatively easy to establish the acquisition cost of an item. However. 7. 7. For example. LCC CONSTRAINTS 8. 7. 9. Equally.5 Performance Trade-off Against Cost. It is of no value having a 24 hour maintenance call-out contract if the equipment fails every day. purchasing decisions are normally made on the acquisition price .1 The acquisition cost of a product can often represent only a small proportion of the total cost of ownership. In many purchasing decisions cost is not the only factor to be considered when assessing the options. -more accurate forecasting of cost profiles. Additionally. CONCLUSION -evaluation of competing options in purchasing.1 Data. LCC analysis allows more accurate forecasting of future expenditure to be applied to long-term costings assessments. Departments should therefore undertake the analysis manually or consider producing simple computer spreadsheets using relatively inexpensive software packages to meet their LCC needs. the purchase of a photocopying machine will be influenced by manufacturers’ claims for reliability of their products. this must be treated with caution especially if it is not contractually binding. Additionally. the availability of the photocopier to a publication department is probably far more crucial than to a general office. Undertaking an LCC analysis can take considerable manpower resources. It is far more difficult to measure the operation and maintenance cost that is likely to be incurred after purchase. and -performance trade-off against cost. 7. Equally. These can be reduced by the use of proprietary LCC models. A worked example is at Annex A. then inflation would have to be considered.

it would be necessary to allow for some standby facility to maintain the required level of output.MAINTENANCE Metred Cost/Copy I Operator Cost of Un-Jamming 7 . In the case of the latter. All costs are expressed at year ‘0’ prices. In this example. It is also assumed that the machines are deployed at separate locations around the building not as part of a continuous flow print room. There are 2 copiers that fully meet the department’s technical specification together with the quality requirements.792 To ascertain the most cost-effective acquisition in through life cost terms an LCC analysis is carried out.943 0.Annex EXAMPLE OF AN LCC ANALYSIS A department has a requirement for 50 photocopiers capable of producing 40. The anticipated life of the copiers is 5 years.745 0. The 2 proposals are as follows: Copier A Copier B Unit Price for an order of 50 Metered cost/copy fixed in cash terms for 5 years £10. 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. A Discount Rate of 6 per cent in real terms (ie The following example sets out the steps involved in this procedure.890 0.000 copies per month from each copier.0p after adjusting for inflation) is used in the analysis which gives the following discounting factors: Year 0 Year 1 Year 2 Year 3 Year 4 1 0. inflation is assumed to be 4 per cent per year.840 0. The metered cost per copy offered by the suppliers includes maintenance charges and all consumables. STEP 1 PRODUCE A COST BREAKDOWN STRUCTURE / TOTTCOST 1 OPERATION AND MAINTENANCE COSTS ACQUISITION 1 Purchase Costs OPERATIONS Operator Cost Purchase Department costs I Paper I Initial Operator Training On-going Training .9p £8.625 l. Staff costs and consumables will almost certainly rise in line with inflation.

5hr £K 24 22. Copier A being a higher quality machine with better reliability than Copier B is on average 9 per cent more available than its competitor.3 £K 600 565.000 more expensive to buy is some £349.9 177. 8 .0 ~1004.0 207.2 162.0 1 £3215.2 106.7 £5.1 £4.5 Metered cost per copy Adjusted at Copier Copier 4%peryear A B £K Year 0 216.12.5K 2 hrs) £2K £435.831m Average downtime/month/copier 12.0 504.0 504.2 106.8 534.7 213.7 Year 2 Year 3 192.8 hrs 240.8 100. Not only are the meter costs important but also the time expended by the operator in unjamming the machine.4 hrs 10.0 217. This can be calculated as follows: UPTIME Availability = TOTAL TIME With the following data: Copier A Total possible availability Downtime for replacement of consumables/month/copier (company brochures) Downtime for operator un-jamming/month/copier (user experience) Downtime for maintenance engineers/month/copier (expert opinion) 176 hrs 3hrs 4hrs Copier B 176 hrs 4hrs 13.8 100.0 Year 4 184.8 Copier A Copier B 0. Copier B would be unavailable for twice as long as Copier A.2 19.4 hrs 28.75K £2. 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.0 216.75K exceeded by the maintenance costs. The prime criterion for copiers of equal performance is availability for use.4 197.0 475.28.25K £2. The additional investment in purchase will be more than recouped during the life of the copiers.6 21.4 179.8 195.1 hrs 176 .4 20.08Om Copier A although over £ 100. 93% 84% STEP 3: DRAW CONCLUSIONS Mean number of copies between jamming (source: previous experience) Average down-time 5 year cost at £lO/hour Year 0 Year 1 Year 2 Year 3 Year 4 Total maintenance cost Total 5 year LCC 3000 lhr £K 80 75.0p Then discounted at 6% £K £K 240.2 £K 120 113.5K 3 hrs £3K £542. Additionally.1 of un-jamming 5000 0.0 1. The cost of operation although large is committed by the decision to buy the copier and is not affected by the choice.4 71.8 95.25K £431.1 Uptime = Total time 176 176 Availability= .3 hrs The example shows that the acquisition cost is far Operator cost Year 0 Year 1 Year 2 Year 3 Year 4 Paper (£5 per 1000) Year 0 Year 1 Year 2 Year 3 Year 4 On-going training Total operation cost Maintenance (5 years) £K 600 565.4 £1353.2 £K 120 113.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).2 63.7 221.0 230.3 146. Therefore.9p 1 .8 534.2 205.3 161.7 Year 1 199.4 176 .8 95.STEP 2: PRODUCE A COST ESTIMATE Acquisition Analysis Copier A Copier B Purchase costs Purchase department costs (2 man/weeks) (Operator training time required per copier Total training cost (2 operators per copier) at £ 10 per hour x 50 copiers Total acquisition cost Operation (5 years) £537.2 67.0 475.5 E3216. Before the decision can be fully assessed the options should be evaluated in performance terms. or viewed alternatively.6 Operator/supervisor cost £K 5.

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