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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 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

COST OF RELIABILITY FOR THE PRODUCER

cost

Reliability
FIGURE 1

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.

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

Reliability FIGURE 2

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.

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-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:

COST

TIME

TYPICAL COST PROFILE FIGURE 4 4. APPLICATION OF LCC ANALYSIS

-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

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. 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. 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

5.1 In defining the cost of an item, account must be taken of the following: -purchase price; -staff costs including overheads; -training; -training aids; -support equipment - special tools, documentation etc; -transportation and handling; -operating; -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; -cost estimating; -discounting; and -inflation. Cost Breakdown Structure (CBS) 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:
Purchase Management Documentations Equipment Support Equipment

7
TOTAL COST

O P E R A T ION AND MAINTENANCE

OPERATION

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
Modlflcatlon

MAJOR PROJECT COST BREAKDOWN STRUCTURE FIGURE 5

1T-
TOTAL COST Purchase Cost

I
Initial Training Operator Manpower

I
Fuel &Consumables

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. 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

I
Training

Maintenance

Contract

MINOR PURCHASE COST BREAKDOWN STRUCTURE 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. 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. Life Cycle (years)
I , I I ,

-expert opinion: although open to debate, it is

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

, /

I /

I I

10

11

12 13

I I

THE EFFECT OF DISCOUNTING ON THE COST PROFILE FIGURE 7

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. 7.1 LCC BENEFITS There are 4 major benefits of LCC analysis:

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

-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.

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

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. The metered cost per copy offered by the suppliers includes maintenance charges and all consumables. 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 10,745 0.9p 8,625 l.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 0.943 0.890 0.840 0.792

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

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.

STEP 1 PRODUCE A COST BREAKDOWN STRUCTURE


/ TOTTCOST

1
OPERATION AND MAINTENANCE COSTS

ACQUISITION

Purchase Costs

OPERATIONS Operator Cost

Purchase Department costs

Paper

Initial Operator Training

On-going Training

- MAINTENANCE Metred Cost/Copy


I

Operator Cost of Un-Jamming

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)

537.25K 431.25K 2.5K 3 hrs 3K


542.75K

2.5K 2 hrs) 2K
435.75K

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. 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 = 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 13.3 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 600 565.8 534.0 504.0 475.2 K 120 113.2 106.8 100.8 95.0 1.5 E3216.3

K 600 565.8 534.0 504.0 475.2 K 120 113.2 106.8 100.8 95.0 1 3215.8

Copier A Copier B 0.9p 1 .0p Then discounted at 6% K K 240.0 217.4 197.4 179.2 162.5

Metered cost per copy Adjusted at Copier Copier 4%peryear A B K Year 0 216.0 207.7 Year 1 199.7 Year 2 Year 3 192.0 Year 4 184.6 Operator/supervisor cost K

5.4 hrs

10.8 hrs

240.0 216.0 230.8 195.7 221.9 177.7 213.3 161.3 146.2 205.1 of un-jamming 5000 0.5hr K 24 22.6 21.4 20.2 19.0
~1004.1 4.831m

Average downtime/month/copier 12.4 hrs 28.1 hrs 176 - 12.4 176 - 28.1 Uptime = Total time 176 176 Availability= . 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 75.4 71.2 67.2 63.4


1353.7 5.08Om

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.