Company Cost

¶ … determinant of the overall profitability of a company. In many instances both labor and product costs comprise a vast majority of a company's expense. Many companies in an effort to mitigate the effects of rising costs have outsourced much of their labor or input costs to other countries. Asian countries in particular have been used extensively for their low cost labor. Through use of cheaper material and labor companies have been able to report higher profits and higher revenues.

In fact, corporate profits as a percentage of GDP are currently at an historic high of 10%. This suggests that many companies have used many cost cutting initiatives to help lower costs while revenue growth remains stagnant or low. An important component of cost reductions are life cycle cost analysis (henceforth referred to as LCCA). LCCA is often used as a tool to help determine the most cost effective manner in which to purchase, own and operate an item.

Its fundamental premise is grounded in the Net Present Value methodology with some changes to the overall concept. LCCA however is critical for the financial success of both business and not-for-profit institutions in American and developed world. It allows for a systematic approach to appropriately judging the cost of capital for projects, irrespective of the industry To begin, what aspect that is critical in the LCCA analysis is scoping. Scoping helps investors determine what cost aspects should be included in the analysis or not.

There are complications that apply with the scope as it relates to LCCA. For example, if the scope becomes too large the tool may become impractical to use and of limited ability to help in decision-making. This often stifles creativity, innovation and capital planning. However if the scope is too small, then the results may be skewed by the choice of the factors considered such that the output becomes unreliable. This can create problems overall with the investment decision, if it is based on information that is not reliable.

Therefore LCCA can be very difficult to assess. Although difficult to assess this process is very important in regards to valuing capital projects. For one, it takes into account all costs associated with acquiring an asset. This is particular important and useful when comparing projects against one another. In addition, LCCA can be used to help determine cost savings between projects. Costs, as mentioned earlier, are a key determinate to the profitability of a firm. LCCA is therefore used to help determine the overall costs of a project alternative.

These cost are often related to both operating and non-operating costs. These include fuel costs, initial purchase costs, residual values, finance charges and non-monetary benefits. When the LCCA method is used, these cost are often increased by a standard amount. This amount is usually comprised of overall industry costs plus inflation. These alternatives are compared to one another to determine which one provides the lowest overall cost consistent with quality.

In addition to the cost and quality factor mentioned above, any company using the LCCA must determine an economic factor to be used in the evaluation. What makes this very difficult is that macroeconomic factors are inherently difficult to predict. For example, an investor must determine the economic effects of alternative designs of buildings and building systems to quantify these effects and express them in dollar amounts. Even more important the investor must discount these rates at an appropriate discount rate.

This discount rate is vital as small changes can have a large impact on the overall value attributed to the savings. What makes this calculation complicated in the uncertainty regarding future interest rates? This is particularly true in the current interest rates environment. Interest rates are at historic lows. Many pundits believe interest rates will rise soon. However the Federal Reserve has stated otherwise. Who should the investor believe? This is the critical factor in LCCA assumptions and valuations. Many simple use a historical average of interest rates.

This however may understate or overstate the value of the asset. As can be seen, the discount rate, and overall interest rates are critical factors to determining value. These factors much like the others mentioned above are based on assumptions. The investors analysis must therefore be correct and through in order to arrive at an appropriate valuation. If the analyst's assumptions are correct the LCCA model can derive significant cost savings for the firm.

However, if the calculations are in error, the firm may end up losing money due to inaccurate calculations by the analyst. Another concept in LCCA is that of economic earnings or economic value added. Investment value can be conceived in a litany of ways. An emerging approach is called Economic Value Added or EVA. EVA is the calculated as Net Operating Profit After Tax (NOPAT) minus the cost of capital, multiplied by.