A New Marketing Tool:
Life-Cycle Costing
Robert J. Brown
Life-cycle costing is a method of calculating the total cost of
ownership over the life span of the industrial product. It can be
especially useful in the marketing of industrial products that
sell for high initial prices, but which provide long-run cost
savings. This paper explains the life-cycle concept
implementation.
Industrial products which find a market primarily on
the basis of lowest initial cost are not necessarily those
which cost the least in the long run. Costs incurred in the
years after purchase may be significant, often far exceed-
ing initial cost, and should be included in any purchase
analysis. The method used to determine the total cost of a
purchase over its life cycle or planning period is known
as life-cycle costing. The purpose of this article is to
explain the concept and use of life-cycle costing. The
subject should be of interest to both buyers and sellers: to
buyers so that they can better evaluate purchases, and to
sellers so that they can better plan and market their
products.
Life-cycle costings most important use is in product
Address correspondence to: Professor Robert J. Brown,
Pennsylvania State University, Middletown, PA 17057.
@ Elsevirr North Holland, Inc., IY7Y Industrial Marketing
analysis where costs expected over the assets life are
large relative to the purchase and installation costs. Fac-
tors of particular relevance are length of life and mainte-
nance and operation costs. Initial cost will probably
and its dominate for a short-lived asset while post-purchase costs
will be more significant for long-lived assets. Where
economies on maintenance and operation costs can be
effected, LCC (life-cycle costing) can clearly demon-
strate the savings. Examples of products on which LCC
analysis is likely to be fruitful are: HVAC (heating,
ventilation, and air conditioning) systems, pollution con-
trol equipment, heavy industrial equipment, farm equip-
ment, earth movers, hospital facilities, computers, ceil-
ings, floors, cables, cars, buses, telephone installations,
etc.
Life-cycle costing is not a new concept. It has been
used by the United States Department of Defense for a
quarter century. What is new is the surge of interest in its
use in the 1970s. The U.S. General Services Administra-
tion, Department of Health, Education and Welfare, Na-
tional Aeronautics and Space Administration, Environ-
mental Protection Agency, and other Federal agencies
have now begun to avail themselves of LCC. Since 1974,
seven states (Florida, Alaska, North Carolina, New Mex-
Capitol Campus,
ico, Washington, Texas, and Maryland) have passed laws
Management 8, 109. I 13 (1979) 109
0019-8501/79/02010905/$01.75
requiring LCC analysis in the planning, design, and con-
struction of state buildings.
The primary cause of the increased emphasis on life-
cycle costing has been inflation, in particular, the esca-
lation of energy prices. Expected rising costs of labor,
materials, oil, and other operating and maintenance ele-
ments give greater weight to post-purchase cost estimates
viz-a-viz initial cost. The result is that life-cycle costing,
which allows for both categories of costs, is becoming an
essential evaluative technique.
THE METHOD
There are two basic life-cycle costing methods: present
value and average annual cost. The former reduces all
dollar costs and benefits of a project to present value
while the latter converts them to an average annual fig-
ure. If the length of life of competing projects is identi-
cal, both methods will rank the projects in the same
order. However, the information obtained from both
methods may be useful. For example, the present value
method may reveal that equipment A will have a life-
cycle cost of $10,000 less than B, while the average
annual cost method will show that the average annual
difference is only $200. The buyer may hesitate to incur
an additional $10,000 cost to obtain a nonquantifiable
benefit associated with B, but may have a changed opin-
ion upon realizing that the difference averages out to only
$200 a year.
If competing assets have different expected lives the
present value method is not appropriate without some
adjustment for the difference. The average annual cost
method may, however, be used for comparison. Informa-
tion needed for LCC is as follows:
1. Initial cost: this will include
cost of delivery and
installation.
2. Length of life: number of years of life or of the
planning period.
ROBERT J. BROWN is Associate Professor of Finance at
Caprtol Campus of The Pennsylvania State University. Dr.
Brown holds M.B.A. and Ph.D. degrees from New York Univer-
sity. His recent research has been devoted to life-cycle costing,
on which he has lectured before government and privately
employed groups. He is coauthor of a workbook on life-cycle
costing which is soon to be publrshed.
For a more extensive history of life-cycle costing see Williams 121.
110
3. Terminal value: this may be a benefit if it is a
salvage value or a cost if it is a removal estimate.
4. Maintenance: average annual cost of maintaining
the asset as well as any periodic replacement of
parts.
5. Operation: average annual cost of energy, labor,
materials, supplies, insurance.
6. Relevant taxes: investment tax credit, tax benefits
from depreciation.
7. Discount rate: future costs must be discounted for
the time value of money to the firm.
8. Escalation rate: estimated rate at which costs will
grow as attributable exclusively to inflation.
Solving by the present value method is essentially the
same as described in the capital budgeting section of any
basic textbook on financial management (see, for exam-
ple, [ 11). The formula to be used for discounting a single
value (e.g., the terminal value) is:
T
p = (1 fr)
where Y = discount rate, T = terminal value, n =
length of life in years, and P = present value of T. If
tables are utilized, T may be multiplied by the present
value factor.
The formula for present value of a uniform annual
series (e.g., maintenance and operation) is:
PA- c
1
L (l+r>,
/=I
where C = uniform annual cost and t = the year in
which the cost is incurred. Present value tables will
provide the factor for a uniform annual series.
If a cost is expected to escalate at rate r, the appro-
priate formula is:
p = U(Q-l) c,
a-l
where a = (1 +r)/(l +r). A brief table of discount/
escalation factors, developed by computer program, is
provided in Table 1.
The discount rate to be used is the buyers cost of
capital. The buyer may be willing to provide the rate or
the seller may estimate it.
Since expenses are tax deductible they should be mul-
tiplied by (100% - TR) where TR is the tax rate. The
TABLE 1 average annual value may be found by multiplying by the
Present Value Factors for Annual Expenses that are Escalating: Capital Recovery Factor. The formula is:
Life 20 Years

Escalahon Rate r(1 fr)

A = (l+r)-1
Discount
Rate 5% 6% 7% 8%
where A is the average annual value to which a present
6% 18.133620 20.000000 22.103420 24.477340
value of $1 is equivalent.
8% 15.075810 16.532210 18.165020 20.000000
10% 12.717780 13.867230 15.151140 16.588210 In the Compound Interest Tables the Capital Recovery
12% 10.874180 11.793080 12.815220 13.954010 Factor for 20 years at 10% is found to be 0.11746. The
average annual cost of each type of equipment is:
Source: Authors computer program.
A: $66,431 x 0.11746 = $7,803,
investment tax credit is the amount by which the Federal B: $68,038 x 0.11746 = 7,992.
Income Tax is to be reduced. Depreciation is the annual If the present value has not been calculated, it may be
amount by which the original cost is expensed and it easier to convert the costs and benefits to average annual
provides a tax benefit of TR multiplied by the deprecia-
values directly. However, escalated values must first be
tion amount. converted to present value (calculations are provided in
As an example of the use of LCC, take the case where Table 3).
a buyer is interested in purchase of a water chiller of The $190 average annual cost differential in favor of A
180-ton capacity. The manufacturer has two models (A leads to the same preference as the present worth method.
and B) available, and the buyer wishes to choose between The average annual cost method, however, provides a
them on the basis of cost. Details on the two models and different perspective in quantifying the yearly cost.
determination of the life-cycle cost of each are provided Whereas the $1,607 present worth differential could
in Table 2. Although Model A has an initial cost $2,000 seem an impressive saving, it is possible that the decision
greater than B, A has a life-cycle cost $1,607 less than B. maker would consider other benefits of Model B worth
If the present value has already been calculated, the the additional $190 yearly difference.

TABLE 2 DISCOUNTING
Present-value Method of Solution
Anyone who has ever utilized the net present-value
Model A Model B
method for capital budgeting will recognize the applica-
Initial cc& $28,000 $26,000 tion to LCC analysis. The only distinction is that LCC is
Annual kWh consumption 150,000 165,000
Operation and maintenance TABLE 3
(3,000 x 10.87418 x 0.52 =) 16,964 16,964 Average Annual-cost Method of Solution
Power
(150,000 x 0.03 x 12.81522 x 0.52 =) 29,988 Model A Model B
(165,000 x 0.03 x 12.81522 x 0.52 =) 32,986
Investment tax credit ( 2,800) ( 2,600) Initial cost (X 0.11746) 3,289 3,054
Depreciation tax benefit Operation and maintenance
(28,000 + 20 x 0.48 x 8.51355 =) ( 5,721) (16,964 x 0.11746) 1,993 I.993
(26,000 + 20 x 0.48 x 8.51355 =) ( 5,312) Power
Present value of costs 66.43 I 68,038 (29,988 x 0. I 1746) 3,522
(32,986 x 0.11746) 3,975
Present value differential in favor of A: $1,607 Investment tax credit
(2800 x 0.11746) ( 32%
Benefits in parentheses.
(2600 x 0. I1 746) ( 305)
Includes sales tax. shipping, installation.
Depreciation tax benefit
Based on customers estimated operating needs. (1400 x 0.48 =) ( 672)
Customers annual discount rate: IO%. Life cycle: 20 yr. Estimated escala- (1300 x 0.48 =) ( 624)
tion rate of power: 7%. Estimated escalation rate of operation and maintenance:
5%. Investment tax credit: 10%. Customers tax rate: 48%. Annual operation Average annual cost 7,803 7,993
and maintenance cost of each model: $3,000. Power cost ($/ kWh ): $0.03. Average annual cost differential in favor of A: $190
Depreciation method: straight line.

111
the term generally applied to analysis of a subset of
capital budgeting problems: projects that do not generate
revenue. The latter may be divided into two types:
Type I. Projects intended to produce economic ben-
efits, e.g., devices to reduce the cost of
labor or energy.
Type 2. Projects intended to produce benefits other
than economic ones, e.g., pollution control
equipment, public schools, defense installa-
tions.
The objective of LCC analysis of both Type 1 and 2
projects is cost minimization rather than revenue
maximization.
The appropriate discount rate for Type 1 and Type 2
projects is the marginal cost of capital, i.e., the cost of
raising the additional funds needed for the project. Some
firms add a few percentage points fudge factor to their
cost of capital for net present value analysis of revenue-
producing projects, but this should not be done for LCC
analysis of Type 1 and Type 2 projects because the
results will be misleading.
Upward adjustment of the discount rate reduces the net
present value of the cash flows. When applied to net cash
inflows from a prospective project the procedure causes
Post-purchase costs will be more significant for
long-lived assets.
the projects benefits to be evaluated conservatively.
However, such an adjustment for an LCC analysis of a
Type 1 or Type 2 project, where outflows rather than
inflows are involved, would reduce the present value of
the periodic costs. Such an effect would be undesirable.
PAYBACK
Payback is the period required to recover initial outlay,
and has traditionally been an important consideration for
revenue-producing projects. Projects with attractive pros-
pects simply wont be accepted by many firms unless the
payback period is less than a prescribed minimum. Sell-
ing to such firms by LCC analysis may require some con-
sideration of payback.
112
Type 1 assets provide economic benefits in the form of
reduced costs and payback may be measured as the
number of years it will take to recover initial outlay from
the cost savings. Although a rough approximation may
be obtained by dividing the annual savings into first
cost+btaining what may be termed the base payback
period-this would ignore the time value of money and
could over- or understate the payback period. A more
accurate figure can be obtained if the payback definition
is interpreted as the period needed to recover outlay from
the cost savings discounted. This latter period may be
termed the true payback period.
The true payback period will be the same as the base
payback period if the cost savings escalate at the same
rate as they are being discounted. For example, a new
lighting system costing $12,000 and producing operating
and maintenance savings of $3,000 a year will have a
base payback of four years. If the savings escalate at 8%
a year and are discounted at 8% a year, the true payback
will be four years (see Table 4 for calculations). On the
other hand, if savings escalate at 2% a year and the
discount rate is lo%, the true payback is 4.98 years or =
5 years (see Table 5 for abbreviated calculations).
Payback analysis may also be used for both Type 1 and
Type 2 projects where the initial costs of competing
projects differ and where the objective is to determine the
time period required to recover the difference (assuming
that the one with the higher first cost has the lower life-
cycle cost). The water chiller problem can be used for
illustration (Table 6).
The buyer now has three helpful pieces of information
about the water chillers: (1) model A will have a life-
cycle cost $1,607 less than B; (2) the average annual cost
of model A will be $190 less than B; and (3) the true
payback for the additional $2,000 initial cost of model A
will be 10.5 years. In the light of this lengthy payback
period, the cost advantage of A may seem of little conse-
quence. In any case, however, the three bits of informa-
tion are available to the buyer and should be helpful in
decision making.
TABLE 4 TABLE 6

Annual Cumulative Initial cost of A $28,000 less 10% = $25,200

Year Return Return Initial cost of B $26,000 less 10% = 23,400
Amount to be recovered: $ 1,800
3,000 (1.08) =
1 3,000 3,000
(1.08) Annual Cumulative
Year Return Return

450 (0.52) (1.07) ~ 100 (0.48)

1 183.98 183.98
(1.10) - - (1.10) =
3,000 (1.08)J =
4 3,000 12,000
(1.08)

etc.

CONCLUSIONS True payback = 10.5 yr

Life-cycle costing has value as a marketing tool for a

great many individual products. Although its use is still
limited mainly to building components and heavier
equipment, it can be utilized fruitfully for lighter indus-
trial goods and for many consumer goods, e.g., au-
tomobiles, appliances, home heating units, storm win-
dows. The list of products to which it can be applied is
virtually endless.
The term life-cycle costing is not yet a part of the
vocabulary of the average citizen, but as the concept
becomes better understood it will have an enormous
impact on the buying and selling of industrial goods and
services. As buyers integrate factors such as operating
and maintenance costs and length of service into their
purchasing decisions through LCC analysis, suppliers
will be forced to consider these factors in product de-
velopment , pricing, and marketing decisions. Some
increasingly cost-conscious and intolerant of inflation,
suppliers who choose to ignore life-cycle costing risk
negative economic consequences.
APPENDIX
An abundance of literature on LCC is available, but
not readily accessible in textbooks or journals. The prin-
cipal sources are United States Government documents.
For those who wish to read further on the subject, a brief
bibliography is provided. Works have been selected for
conceptual and technical content as well as for their
appended lists of further references.
Department of General Services, Florida Life Cylr Analysis Manual, Tal-
lahassee, Florida, March 1975.

firms are already fully aware of LCC and utilize it in Indusfrializarion Forum. Vol. 6, 1978. (Entire issue devoted to life cycle
costing).
planning, buying, and selling, but widespread use of it
K G Associates, Life Cycle Cost-Benefir Analysis: A Busic Coursr in Eco-
has yet to be realized. In a society that is becoming nomic Decision Making, Dept. of Health, Education and Welfare,
Washington. D.C.. March 1976.
General Services Administration, Federal Supply Service, Lif, Cycle Cosriqt
TABLE 5 Procur~mcwt Case I, Room Air Condi/ioners, Washington, D.C., July
1975.
Annual Cumulative
American Institute of Architects, Lifi, Cycle Cost ArluIy.6~. A Guide ,fbr
Year Return Return
Architects, 1977.

3,000 (1.02) = U.S. Department of Commerce, Lifi, Cycle Caring Emphusizing Erwrg~
I. 2,781.82 2,781.82 Corwrwtion: Guidelirws for InwstmentAmz/ysis, Washington, D.C..
(1.10)
September 1976 (revised May 1977).

REFERENCES
3,000 (1.02) =
4. 2.217.95 9,971.17
(1.10) 1 Philippatos, George C.. Esserlrials of Finmcicrl Manogrmrr~t. Chap. 4,
3,000 (I .02) Holden-Day, San Francisco, 1974.
5. 2.056.64 12,027.81
(1.10) 2 Williams, John E., Life Cwle Costing: A Overvirw, Joint Conference of
American Institute of Industrial Engineers and American Association of
Interpolate to obtain 4.98 years. Cost Engineers, Washington, D.C., October 5-6. 1977.

113