Life Cycle Costing Woodward (1997)

Life Cycle Costing

Woodward (1997) outlines the concept of life cycle costing. At the heart of the concept is that costing decisions should be made on the basis of total costs of an asset of its lifetime, rather than the initial purchase cost. Woodward then outlines the procedure for implementing life cycle costing. The main components of life cycle costing are the cost elements of interest; the costs associated with development, with production and implementation and with operation.

The eight steps of life cycle costing are describing the operating profile; identify utilization factors; identify every cost element; identify critical cost parameters; calculate all costs at current rates; all costs should be projected forward at appropriate rates of inflation; discount costs for time value; and sum all present values.

Woodward outlines the different elements of life cycle costing as initial capital costs; life of the asset; discount rate; operating and maintenance costs; disposal cost; information and feedback; and uncertainty and sensitivity analysis. He then describes each of these in detail.

Life cycle costing, according to the author, is valuable because it can help the firm identify the point at which the initial costs and maintenance costs are at the minimum. The underlying principle is that for any asset purchase, there will be a tradeoff between initial cost and maintenance cost and this technique can be used to minimize the total cost.

While the underlying principle of life cycle costing is reasonable, the author fails to explain some of the underlying assumptions. For example, while LCC as explained here incorporates many elements of a basic net present value analysis, the author fails to explain how the LCC model is superior to NPV in making capital budgeting decisions. The underlying concept that lower initial costs do not necessarily improve profit is fair, but is already incorporates into NPV, with the addition of assumptions on how lower initial cost affects the revenue side of the decision. It is this revenue side that is not included in LCC modeling, and the value of only evaluating one side of the profit equation is not justified by the author.

Taylor's article (1981) is an introductory piece on the concept of life cycle costing. The underlying theory as Taylor describes it is "to ensure the best use of physical assets to the lowest total costs to the organization" (p.32). These include construction (acquisition) costs, operating costs and maintenance costs. It is based around the premise that all costs both present and future must be recorded, and in present-day values.

The author also discusses how to introduce life cycle costing to the organization. The technique is expensive, given the need for extensive data collection, but it is also the most valuable to the organization. It delivers on the fundamental objective of asset management, which is that the organization should seek to choose from among a set of alternatives the option that provides the best value over the entire life of the assets in question.

Taylor's article goes on to explain some of the concepts used in the implementation of life cycle costing, including the gathering of data, the derivation of present value and the analysis of multiple options. He highlights the importance of the idea that life cycle costing is not merely a tool to be used to make capital acquisition decisions but should be used throughout the life of the project.

Taylor's work introduces the concept and provides a good primer for the practitioner on how to implement life cycle costing. He also makes a rudimentary case for the methodology, though without comparison to other common methodologies. The article is nonetheless a strong introduction to the concept on which further knowledge can be built.

Ashworth (1989) puts the underlying hypothesis of life cycle costing to the test. This hypothesis is defined by the author as "life-cycle costing will help us to select the most economic solutions for a design, taking into account all the costs arising from the project." The author tested this hypothesis by analyzing a variety of case studies dating back into the 1960s, with specific respect to buildings.

The author questions whether or not the technique can be realistically applied to buildings and other very long-term assets. Changes in the external environment -- in fashion, technology, and in costs can dramatically alter the projections undertaken in the initial analysis. If such changes occurred, it would undermine the most fundamental purpose of life cycle costing -- to choose the projects with the highest economic value over their entire lives.

Despite the claim of using historical data, the author fails to do so. Instead, the author relies heavily on anecdotes carefully constructed to prove his point. The findings of the author, since no actual analysis has been conducted, naturally support his original contention. The reasonable reader, however, will understand that in undertaking a decision today, one cannot predict all future unknown occurrences. One must simply approach the problem with the best information available to day. Life cycle costing is, after all, only intended to deliver the best possible results. Results that depend on perfect vision into the future are, to all but the most experienced of carnival gypsies and fortune tellers, impossible results. The author comes to the conclusion that only perfect information about the future would yield perfect results, a conclusion that is not only self-evident but given its impossibility is utterly irrelevant to the debate about life-cycle costing.

Lindholm & Suomala (2007) highlight some of the practical issues with regards to gathering sufficient and accurate data to properly engage in life cycle accounting. They begin with an understanding of life cycle accounting as involving a complex set of interrelated costs. The relationships between all of the different cost elements must be understood in order to properly derive the information needed to conduct a proper life cycle costing analysis.

The authors propose that Monte Carlo simulations can be used to help model some of the uncertainty associated with future costs with probability distributions. A sensitivity analysis can then be conducted to help determine the most important variables in the cost analysis. With probability distributions and uncertainty analysis, management can derive stronger estimates of future costs to use in the life cycle costing model. The model would begin with historical costs and incorporate the outputs of the Monte Carlo and the sensitivity analysis.

This contribution to the literature on life cycle costing is valuable because it represents an adaptation from other costing techniques that improves the accuracy of the assumptions in any life cycle costing model. While it is impossible to see into the future with 100% clarity, it is reasonable that a manager who wishes to utilize the life cycle costing model should understand the limitations of that model and attempt to mitigate the impact of these limitations. In doing so, stronger results will be achieved and the manager will receive a higher probability of successfully choosing the option with the lowest life cycle cost.

Steen (2005) attempts to apply the concept of life cycle costing to environmental costs. He acknowledges the strength of the model in analyzing conventional costs, but determines that environmental cost accounting is gaining adoption among companies, in particular those wishing to put forth a green face to their external stakeholders.

Steen's paper posits that the first step is to identify the environmentally-related costs to a company. These can take many forms, and it is important to define them. Some are direct -- fines levied by environmental protection agencies or capital investment to reduce pollution or other negative environmental outputs. Some are indirect -- the depletion of a resource may require more expensive substitutes, alternative techniques or the premature exit from a business.

Steen finds that the LCC technique can reasonably applied to environmental costing. As the latter is largely a management accounting concept, there is considerable leeway for managers as to what costs should reasonably be included. However, it is Steen rightfully argues that such costs should be included in any LCC model created. There is some overlap between Steen's work and that of Lindholm & Suomala, who mention that the total costs of a project are open to interpretation and can include costs to the external environment and other relatively indirect stakeholders.

Part II:

Life cycle costing has developed since its inception to become a useful tool for managers. It is, for example, one of the underlying theories in net present value calculations, which are popular in capital budgeting. In this usage, life cycle costing appears to have become somewhat moribund, in part due to its status as an incomplete version of the NPV assessment. However, in recent years academics have breathed new life into the idea of life cycle costing, by applying the concept to a wider range of cost tasks. One of the more interesting is the application of life cycle costing to the concept of environmental costing. This application showcases the strengths of life cycle costing perhaps more clearly than does its usage as a tool strictly for the purposes of capital budgeting. 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.