This essay provides knowledge about:
* Concept of Life Cycle Cost Analysis
* Why Life Cycle Cost Analysis used
* Theoretical steps to compute Life Cycle Cost
* A typical example of Life Cycle Cost Analysis with real life values (Case Study).
Life cycle costing, LCC, is the process of economic analysis to asses the total cost of ownership of a product, including its cost of installation, operation, maintenance, conversion, and/or decommission.
LCC can be used to choose best alternative among a set of options.
By using LCC, total cost of the product can be calculated over the total span of product life cycle.
LCC is an economic tool which combines both engineering art and science to make logical business decision.
This analysis provides important inputs in the decision making process in the product design, development and use.
By using LCC, product suppliers can optimize their design by evaluation of alternatives and by performing trade-off studies.
With the help of LCC product suppliers can evaluate various operating and maintenance cost strategies (to assist product users).
It is equally important for customers or end users also. By using LCC, customers can also evaluate and compare alternative products, at their end.
Customers can assess economic viability of projects or products, by using the concept of LCC.
LCC Analysis can be done for any tangible thing, where cost is involved; like, any equipment, system, plant, technology, installation, service, or even software and IT enabled quality control system also.
Why LCC?
Every organization is combination of various inter-related departments. Every department tries to maximize its activity, and tries to prove its superiority over other departments. Even though, all departments try to achieve organizations overall objective, but in reality they work to protect their departmental interests. In many cases, it becomes detrimental for the health of organization. This conflicting behavior increases when organizations strategy works on subjective decisions. When company’s strategy works on objective platform, chances of conflict reduce.
Typical conflict in most of the company:
* Project Engineering wants to minimize capital costs as the only criteria,
* Maintenance Engineering wants to minimize repair hours as the only criteria,
* Production wants to maximize operation hours as the only criteria,
* Reliability Engineering wants to nullify failures as the only criteria,
* Accounting wants to maximize project net present value as the only criteria,
* Shareholders want to increase stockholder wealth as the only criteria.
LCC can be used as a management decision tool for synchronizing the divisional conflicts by focusing on facts, money, and time.
Why should engineers be concerned about cost elements?
It is important for engineers to think like managers and act like engineers for a profit maximizing organization.
Ultimately, Money Does Matter!!!
LCC divides the cost element of an equipment.
For an equipment, there are TWO cost elements:
1) Initial Cost, and
2) Operation & Maintenance Cost
The identification of cost elements and their sub-division are based on the purpose and scope of the LCC study.
Initial Cost:
* Design & development cost,
* Investment on asset, or cost of equipment,
* Installation cost or erection & commission cost.
Operation & Maintenance Cost :
* Labour cost,
* Energy cost,
* Spare & maintenance cost,
* Raw material cost.
Computation of Life Cycle Cost Analysis (Steps for LCCA) :Steps for computation of LCC
Step 1: Determine time for each cost element,
Step 2: Estimate value of each cost element,
Step 3: Calculate Net Present Value of each element, for every year (over its time period),
Step 4: Calculate LCC by adding all cost element, at every year,
Step 5: Analyze the results.
Details of different steps are given below.
Step 1 : Determination of time
This mean determination of life cycle of the product (i.e. equipment, in this case).
This Life cycle is not similar to conventional concept of Product Life Cycle.
Conventional concept of Product Life Cycle implies to the time span based on demand of the product in the market, starting from launch of the product up to the time when company withdraw the product from the market. That is purely a marketing concept.
In LCC analysis of an equipment, life cycle means the life of the product that is installed in the plant, i.e. productive life time of the product.
The product supplier provides the life cycle depending on design calculation and experience.
Based on supplier’s data, customer decides the Life Cycle, i.e. how long he/ she wants to use the machine. Customer considers the effect of available maintenance facility, technological obsolescence and economic uncertainty factor, also.
After that, company decides the time span for each component.
Example, say, a company decides that total life cycle of the product will be 10 years from the allocation the fund, among which first one year will be initial cost zone and remaining 9 years will be under operation and maintenance cost zone.
Step 2 : Estimation of value
* Estimate monetary value for each cost element.
* This estimated value will be incurred in every year. This value is basically future income at each year, which is estimated.
* To estimate the value, various sources can be used; e.g. calculation based on facts and experience, MIS report for similar existing machines, etc.
Step 3 : Net Present Value
* Money has a time value.
* The present value of future income or future cost can be calculated by using discounting factor and inflation factor.
o Discount factor
The discount rate is an interest rate, which a central bank charges depository institutions that borrow reserves from it.
For example, let's say Mr. Ram expects Rs. 1,000 in one year's time. To determine the present value of this Rs. 1,000 Ram would need to discount it by a particular rate of interest (often the risk-free rate but not always). Assuming a discount rate of 10%, the Rs. 1,000 in a year's time would be equivalent of Rs. 909.09 to Ram today (i.e. 1000/[1+0.10]).
o Inflation factor
The inflation rate is the percentage by which prices of goods and services rise beyond their average levels. It is the rate by which the purchasing power of the people in a particular geography has declined in a specified period.
Formula for Net Present Value (NPV):
PV = [C (1+i/100) ^(n-1) ]/ [(1+d/100) ^n ]
where,
C = any cost element at n th year
I = inflation rate
d = discount rate/ interest rate
Step 4 : Summation of PVs
o PVs of each cost element are calculated for an equipment (at every year).
o PVs of each cost element in a year are added.
o The process is done for every year over the life cycle, i.e. LCC is calculated for every year.
Step 5 : Analysis
o The data collected from LCC are analyzed.
o If one product has to be selected among multiple equipments, then LCC is calculated for every product.
o Datas for every product are analyzed, and the lowest LCC option become preferred.
o But lowest LCC option may not necessarily be implemented when other considerations such as risk, available budgets, political and environmental concerns are taken into account.
An important reminder…..LCC provides critical information to the overall decision-making process, but not the final answer .
Now I want to give you a life example of LCCA, i.e. Estimation of Life Cycle Cost With a typical case study!
Case Study
o A highly productive foundry shop has one sophisticated robot operated moulding machine (made in Europe).
o Due to increase of demand for its casting, the foundry shop wants to install one new moulding machine.
For new machine, there are two options:
o Similar sophisticated robotic machine, or
o Semi-automated machine.
Option 1Initial cost :
o Design & development (D): Nil, as it is a Bought Out Item.
o Investment on asset (A): 59.4 (in INR, million)/ year (One time investment, done at 0th Year.)
o Installation (I): 0.6 (in INR, million)/ year (One time investment, done at 0th Year.)
Computation of PV of Initial Cost (IC):
PV = [{D(1+i/100)^(n-1)}/{(1+d/100)^n}]+[{A(1+i/100)^(n-1)/ {(1+d/100)^n}]+[{I(1+i/100)^(n-1)}/ {(1+d/100)^n}]
From calculation, PV of IC = 55.5 million INR
Operation & Maintenance Cost :
o Labour (L): 0.3 (in INR, million)/ year, 4 workers @ 3 shifts
o Energy (E): 4 (in INR, million)/ year, (Data source: MIS report of existing equipment)
o Spare & maintenance (S): 2.6 (in INR, million)/ year, (Data source: MIS report of existing equipment)
o Raw material (M): 27.7 (in INR, million)/ year, (Data source: MIS report of existing equipment)
Computation of PV of OC :
o Total OC= L+E+S+M=34.6 Million INR
In the previous calculation, expected future values of OC at all the years were same, i.e. 34.6 Million INR.
This expected value can be different for different years, too.
Option 2Different cost element for option 2 (i.e. Semi-automated machine) has been estimated and final calculation for LCC has been done.
The analysis shows:
* Initial cost of semi-automated machine is lower.
* But, the long term LCC is much lower for Robotic machine.
Considering LCCA, the robotic machine is preferred compared to the semi-automated machine, for this particular application.
Residual Cost or Salvage Cost:
In life cycle cost analysis, one additional cost component can be added, i.e. residual cost. The residual cost of a equipment or system is its remaining value at the end of the analysis period. Residual values can be based on resale value, or salvage value, or scrap value, or disposal value. In the analysis, after calculation of resale value for each year, it should be converted to its present value of that year. Then this PV of residual value should be substracted from the LCC of each year to get final LCC value of that year.
Capital Budgeting & LCC:
* LCC is one of the important tool for capital budgeting.
* Economist Joel Dean has suggested that, capital expenditure should be defined in terms of economic behaviour rather than in terms of accounting convention.
* LCC is one of the useful tool which enables investors to analyze investment in terms of economic behaviour.
(Now a days importance of LCCA is increasing. In building engineering, it is almost essential as per various international laws, likewise, USA, Canada, UAE, etc. At present, in UAE, government has launched new guideline called Estidama, where LCCA is mandatory for green buildings. Also, various industyries are now doing LCCA before taking any major industrial decision for sake of accuracy. In that case, LCCA needs to be done with more accuracy by considering different risk factors.)
The same materail is discussed in the following link (with more presenatable form): http://nirjharchakravorti.blogspot.com/2011/03/life-cycle-cost-analysis.html
To discuss more you can mail at:
nirjhar.mechanical@gmail.com
