Life Cycle Costing Woodward 1997  Term Paper

Excerpt from Term Paper :

The successful adaptation of life cycle costing to environmental accounting opens the door for the application of life cycle costing techniques to other emerging areas of managerial accounting. This paper will examine the usefulness of life cycle costing in the context of not only its existing uses but with respect to potential future uses as well. It is expected that this analysis will conclude that life cycle costing is a valuable complementary tool that can be used in a wide range of managerial accounting applications.

The underlying concept of life cycle costing is that a capital asset's "cost" should be taken to incorporate all of the costs associated with that asset over the course of its useful life (Woodward, 1997). The costs, once gathered, could be evaluated against the costs of other projects. Compared to previous methodologies, some of which were incredibly simple, life cycle costing was a leaps and bounds improvement. It factored in not only all costs, but ascribed to those costs the time value of money.

While life cycle costing was perhaps most beneficial for public sector projects, the private sector also made use of the technique in net present value calculations. NPV, which includes the revenues generated from the project and is therefore based on net cash flow rather than simply cost, has become the predominant means by which capital budgeting decisions are made.

Although life cycle costing met with early criticism due to some of its key deficiencies, these criticisms gradually subsided. Some of the criticisms, such as those associated with the quality of the assumptions regarding future costs espoused by authors such as Ashworth (1989), ultimately fell flat because those same criticisms could be applied to any of the costing methods in use. The inputs do rely heavily on assumptions, but so do the inputs of any technique that estimates future costs. This deficiency, therefore, does not detract from the overall strength of the life cycle costing methodology.

Academics have taken the criticisms to heart, however, and searched for ways to mitigate the impacts of uncertainty on the calculations contained in life cycle costing. Lindholm & Suomala (2007) make use of statistical techniques such as Monte Carlo simulations and sensitivity analysis to improve the quality of the assumptions used in life cycle costing. Armed with such techniques, managers can significantly reduce the risk inherent in life cycle costing's assumptions about future costs.

The recent refinements to the process have renewed interest in the value of life cycle costing. One of the most valuable uses for life cycle costing to emerge in recent years is in environmental costing. Environmental costing is an emerging field that attempts to quantify the totality of environmental costs and benefits associated with a firm's activity.

Environmental costing is becoming increasingly popular as firms attempt to quantify for both internal and external stakeholders the environmental impacts of their operations. There is a symbiotic relationship between life cycle costing and environmental costing. In the holistic approach to costing, environmental costing borrows from concepts first established in life cycle costing. Life cycle costing is strengthened by the inclusion of future environmental costs in the equation. The introduction of these costs is a new addition to the practice of life cycle costing, but one which is becoming increasingly important (Steen, 2005). Life cycle costing has always sought to include all costs, but until recent years environmental costs were assumed to be either negligible or irrelevant to decisions regarding capital assets.

The interdependency of life cycle costing and environmental costing illustrates the value inherent in the technique. Managers today face tremendous challenges in analyzing the total costs of any project. if, however, these costs can be broken down into categories, each category can be treated with a life cycle costing analysis and then synthesized into a total analysis for the project.

For managers, the question arises of whether or not there are other uses for life cycle costing techniques. If we look at historical examples, we can understand how such techniques could have been valuable to automakers, for example. Today, U.S. automakers are under constant financial strain, burdened by the weight of pension obligations. While the vastness of these obligations and certain cost elements (such as the dramatic rise in prescription drug costs) would have been difficult to predict, it seems reasonable that the full cost of each employee hired was not fully considered when the manufacturing facilities were designed and union contracts negotiated. The costs are almost definitely higher than management had anticipated. In an era where benefits are as important and can be almost an expensive as wages paid, life cycle costing is a technique that can be valuable to human resource managers.

The value of life cycle costing is highlighted by the way that many companies structure their revenue streams. Many companies use base products as loss-leaders, with the bulk of revenues generated from service contracts, for example photocopier and printer manufacturers. The increasing prevalence of service contract-based revenue streams is mirrored by service contract-based liabilities. Firms need to account for these liabilities when analyzing the total cost of even minor assets such as office equipment or ongoing services such as consulting contracts.

Another relatively recent trend that highlights the value life cycle costing can bring to an organization is the increasing focus of shareholders on quarterly results. This motivates managers towards a short-term time orientation. Such an orientation can lead to decisions that minimize short-term costs but have higher costs over the life of the project. Such decisions will ultimately result in the organization delivering lower value to the shareholders, but will have the appearance of delivering higher value. Increased use of life cycle costing in managerial accounting can result in extending outward the time orientation of managers, allowing the company to deliver better long-term results.

For a time, organizations could have been forgiven for discounting the value of life cycle costing. Its relevance in capital budgeting, for example, was in the extent to which it contributed to more complete models oriented towards net cash flows. Life cycle costing, however, remained a fundamentally strong concept. As such, we have seen new uses for the model emerge in recent years. Its principles can be applied to all asset classes -- human resources, environmental assets and short-term assets included. Moreover, many of the objections to the technique have fallen by the wayside as methods to gain better estimates of future costs have been introduced.

I would implement life cycle costing in my business. I would not use it for its original purpose, the technique having been superceded by NPV calculations in for-profit entities. However, it is a sound technique that can be applied to a wide range of asset classes. There are asset classes with a direct impact on revenues can be difficult to ascertain. In such situations life cycle costing can at least give the organization a sense of the costs involved with the asset of the course of its life. This gives the organization a starting point for stronger analysis.

Lastly, life cycle costing would be valuable in my organization as a means to hold managers accountable to a longer time horizon than they otherwise would adhere to. The temptation in business today is to have a short-term orientation geared to consistent quarter-over-quarter growth. This impacts the decision-making process and gears decisions towards low-risk levels and a short-term time orientation. Life cycle costing, especially if incorporated into the firm's motivation and reward systems, can help to provide managers with a longer time orientation and encourage them to tackle the projects that build the best long-term value for the company.

Works Cited:

Ashworth, Allan. (1989). Life-cycle costing: A practice tool? Cost Engineering. Vol. 31, 3, p.8-11

Lindholm, a. & Suomala, P. (2007). Learning by costing. International Journal of Productivity and Performance Management. Vol. 56, 8, 651-672.

Steen, Bengt. (2005). Environmental costs and benefits in the life cycle analysis. Management of Environmental Quality, an International Journal. Vol. 16, 2, 107-118.

Taylor, W. (1981). The use of life cycle costing in acquiring physical assets. Long-Range Planning. Vol 14,…

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