What Is Life Cycle Costing?
Why Do Life Cycle Costing?
On more than one occasion in my career, I have been told by a superior something to the effect of, “I do not worry about life cycle costing because it costs too much.” Stop and re-read that statement and ponder it. First, it's just a fact that anything you buy incurs costs for the entire time you possess it. So how does analyzing that cost create additional cost? The analysis only creates a greater knowledge base for making the decision of whether to purchase.
Of course, that analysis also draws attention to the costs already committed by an acquisition. In this light, does this concept of “too much” just ring absolutely absurd? When people talk about analysis costing too much, I almost always jump to a conclusion of ignorance. Ignorance isn't necessarily negative; every person is ignorant about many things. It's useful to acknowledge that ignorance because once that is done the ignorance becomes the foundation for learning.
Life cycle costing opens alternative thought processes that can help to create equity in long-term purchasing. Equity can always be built if, at the end of the life cycle, a saving can be created over the alternative options at the original time of purchase.
What Are Life Cycle Costs?
This can be seen in a previous article I wrote about the cost associated with buying a vehicle. Believe it or not, everything we buy has a life cycle cost to it, and let me illustrate that.
Let us say you go to the grocery store and buy a gallon of milk, at a cost of $1.80. You go home and place that milk in the refrigerator and it lasts you about 10 days. Your refrigerator will run 24 hours a day / seven days a week and will use about $.18 per day.
When you add the power consumed to the milk for the 10 days it is expected to be in the refrigerator, the milk will cost for its life cycle $4.60 approximately. Now, this is approximate because each item placed in the refrigerator for those entire 10 days would take a pro-rated share of that energy consumption, so you can see how complicated it becomes to calculate the life cycle cost, especially on short cycle items.
Now let’s say that there was an average of 100 items in the refrigerator during that 10-day period, then the energy used specifically for the milk would only be $.028, now making the cost of the milk $2.828. Now, this would be closer to the cost, but as you can see, this demonstrates that the milk cost about $.03 more if it lasted 10 days.
This would increase or decrease based on the number of days in the refrigerator as well as the number of items in the refrigerator for that time. Now modify that as the number will fluctuate as the number of items in the refrigerator will also change daily, or even hourly depending on the time of day.
The concept is simple, the calculations maybe a little more complicated, but this article is not about how to calculate the life cycle costs, only to convey the concept of what life cycle costs actually are. You can see how the complexity can grow extremely fast when we start looking at larger capital expenditures like vehicles and buildings. The more complex the item acquired is, most likely the more intense the upkeep maintenance will be as well, thus an increase in its life cycle costs. However, the larger the acquisition costs and the longer its life expectancy is, the greater chance of demonstrating huge offsets in even the smallest upgrade in initial costs.
You Must Look at All Costs
If you really want to gain the most accurate picture of life cycle costing, it is incumbent to bring all the costs to the analysis.
This must include:
- total operational costs
- maintenance costs (preventative, deferred, and renewal)
- inflationary costs of operational raw materials
- replacement costs
As can be seen, there are many pieces to be brought to the table when doing a complete life cycle analysis. Leaving any of these out may skew the results to an artificial answer, which I have seen countless times. For instance, if you are doing a life cycle cost of a building, you have to include some system replacement costs. A building’s life may be 40 or 50 years, but most HVAC systems have a life of 12 – 15 years (at the upper end), maybe. If you do not include the replacement costs of these systems, your building life cycle costs are not going to be accurate.
Example of Life Cycle Costing
Now, I will not attempt to provide a complete life cycle cost example here, I do want to show is some of the factors and complexities that need to be included.
To begin with, we must start with the most basic premise: the lowest cost of anything in the future will come today. That means anything not fully purchased today, or if regular maintenance is required, there will be added costs. This is seen when we make a purchase on credit. The pay off amount will always be more than the initial purchase amount, sometimes doubled or more. That is just the cost of the interest for the creditor alone. Keep in mind that this cost does not factor in maintenance, oil changes, tires, painting, etc. That cost has to be part of a complete life cycle cost analysis.
Inflation is also a cost that occurs almost every year. If that needs to be proven, just go to the Social Security Administration website and check the COLA (cost of living adjustment) for the last few years or even decade. Between 2012 and 2018 the SSA COLA has increased 10.8% just as a result of inflation alone, which increases when we go back farther. Keep in mind that this does not look at specific raw materials that may rise faster than inflation. You can see how this can influence a life cycle cost analysis if inflation is not correctly identified, even in raw materials. Many factors may be easier to project than others. The cost of petroleum products is always a shot in the dark as a long-term prediction, inflation, on the other hand, is a little less volatile in a long-term prediction most of the time. However, it is much more difficult to predict spikes and dips along with their magnitudes.
So, let us look at an example. To keep this simple so most readers can follow, we will look only at the inflationary cost impacts for a long cycle system. We are going to compare two systems, one with a 20-year life and one with a 40-year life. We will use an inflationary increase of 2% per year non-compounded to help the math stay simple, and express everything in percentages. So, the first year the system is replaced is our base cost, which we will express as 0% since it is present-day value. For the 20-year system, the system will have to be replaced at a cost of 140% (100% for today’s costs, plus an inflationary cost of 40%), in another 20 years the system will be replaced at 180% (100% for today’s cost plus an inflationary cost of 80%), for a total cost of 320% (140% plus 180%) for the 40-year life cycle. Now if the 40-year system costs up to three times the cost of the 20-year system, and there is still a 20% gain on savings over the 40-year period with the 40-system. If the 40-year system is anything below three times the cost of the 20-year system, then equity is created over the 40-year period, which can be significant. If you would factor in raw material cost for the 20-year replacement, then the savings grow even larger.
Making Decisions Using Life Cycle Costing
As a basic rule the longer the cycle, the better the return. However, this is not always the case. Costs of regular maintenance may have a significant impact on this. If the longer cycle requires more intense maintenance and upkeep, this all gets thrown out the window. A selection can be made that can meet the long-term cycle goals, but a lesser performer may meet those goals as well, creating initial savings that will impact the life cycle outcomes. This would be true for a product that has very long-term stable raw material costs.
I remember when I bought my first new truck in my early 30’s. I had it a few years and it came time to replace the tires. When my tax return check came, I went and bought the really good tires, with the 88,000-mile warranty. Those tires last me about eight years, and still had a great amount of tread on them, however, thanks to the Phoenix heat, the tires were dry rotting and had to be replaced. I realized then that I did not need to spend the additional cost on those 88,000-mile tires and probably could have gained more value for the cost I paid if I drove more miles.
Acquiring a grade of product higher than required is wasting of resources, just as with my tires. Even with life cycle costing, you still need to be focused on the entire picture. You should never buy more than is required.
Life cycle costing may help those that are not the most versed in what they are acquiring. Had I done a life cycle cost for those tires, I might have found out that I might have been better off with a lower grade tire. If you go to your locale home improvement store and go to the door hardware aisle, you will find multiple grades of door hardware.
You will find the cost between the lowest and highest grade to be considerable. The truth is, in most homes, you really only need the lowest grade. The highest grade will most likely be a waste of resources if the house falls down before the door hardware wears out.
As you can see, there are many elements that could be included into a life cycle cost analysis, but you can become impeded by getting into an extreme level of detail. The key is knowing what level of detail to get into, or acceptable tolerance. As an example, a carpenter would see measuring a stud to 1/64th of an inch as ridicules, yet measuring to 1/8th of an inch is more than accurate enough for most work. Keeping in mind this “tolerance” helps manage the process of life cycle costing analysis. What always needs to be kept in mind is that this type of perspective, if executed well, provides a long-term view of possible decisions, and in log-term asset holding is imperative to help that asset last even longer, or at least become more economical to own.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.