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Option Costing May Not Be the Most Inexpensive! Use LCCA to Find Out Why

written by: N Nayab • edited by: Jean Scheid • updated: 6/29/2011

A life cycle cost analysis compares alternative assets or methods that fulfill the same requirements but differ with respect to initial costs and operating costs. Assets with higher upfront costs may provide savings in operational costs and prove more cost-effective, or vice-versa.

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    Life Cycle Cost Analysis A Life Cycle Cost Analysis (LCCA) is a subset of a cost-benefit analysis (CBA). CBA analyzes the various benefits and the related cost for various alternatives whereas LCCA finds use to compare total cost differentials including ownership and retaining costs of various alternatives having similar benefits.

    For example, the Federal Highway Administration (FHWA) applies CBA to justify the making of paved pathways, and then develops a LCCA model to evaluate life cycle costs of paving materials containing asphalt rubber binders and alternate treatments, to select the most cost effective paving method. For instance, a glazing system may require higher upfront cost compared to high-performance HVAC but would result in dramatically reduced operating and maintenance costs. LCCA makes this explicit and confirms the glazing system as a more cost-effective option even though it costs more initially.

    The various stages of calculating LCCA are:

    1. Develop design alternatives that deliver the same structural and performance objectives.
    2. Define the schedule of initial and future activities of the asset or project design and each of the alternatives.
    3. Estimate the costs involved for each alternative.
    4. Find the present value of each alternative through “discounting."
    5. Analyze the results.
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    Develop Design Alternatives

    Life Cycle Cost Analysis Identify and develop a minimum of two mutually exclusive options that serve the same purpose, with the assumption the only economic difference between alternatives is total cost.

    For each alternative, detail the components that make up the option, and define:

    • Activities required to procure, construct, or refurbish the asset
    • Periodic maintenance and estimated repair or rehabilitation tasks required throughout the life cycle

    Assume the Federal Highway Administration selects glazing system and HVAC as two possible alternatives for paving the pathway. Both provide the same purpose. Both project alternatives have different execution methodologies and require vastly difference maintenance activities and schedules. Use knowledge of historical practice, managerial expertise, technical knowledge, research insights, and agency policies to derive the required information.

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    Determine Activity Timing

    Use the information from the define stage to develop for each alternative, a maintenance and rehabilitation plan that details the times when such activities occur, and the costs involved for each activity.

    Such analysis requires understanding the deterioration the asset would suffer through use, age, natural wear and tear, and other factors, the impact of such deterioration on performance or output, and the level of maintenance required to ensure output remains constant in such deteriorations. Information comes from performance records of existing assets, supplier, or manufacturer catalogs, findings of outside research, and benchmarking from local, regional, and national sources.

    Although different alternatives may have different life cycles, LCCA requires applying the same timeframe over all alternatives for analysis, to ensure consistency of comparisons. Applying an equal duration, for instance allows comparing the number of times different alternatives require maintenance over a specified period, and holding costs over the same time. A sound analysis requires taking a sufficient large duration that incorporates various routine and maintenance activities of all alternatives, and minimizes chances of exceptions creating distortions.

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    Estimate Costs

    Apply costs to the various activities defined and scheduled in the first two steps. Common inclusions are procurement costs, day-to-day maintenance costs, expenses to address safety and operational requirements, cost of raw materials such as fuel, annual costs to replace spares, and more.

    LCCA requires only costs that vary or differ, allowing the option to exclude expenses common to all alternatives, such as land cost. Best practices for the LCCA, however, requires including costs incurred by the agency holding the asset and costs to the user. For instance, a transportation project requires considering both costs incurred by the operators and costs incurred by the traveling public. This makes the analysis more complex, but more reliable and accurate.

    One important consideration when estimating costs is the salvage value or remaining service life (RSL) of the asset at the end of the analysis period. Failure to incorporate such salvage RSL costs, or making wrong estimates of such costs can distort the estimates considerably.

    The success of the analysis depends on accurate estimates of such costs. Ways to determine costs include referring to historical records, current bids, and making engineering or managerial judgments.

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    Compute Life Cycle Costs

    Compute total costs for each alternative to allow for a direct comparison. A direct addition of all costs creates distortions for inflation, and opportunity-costs make the present value of money different from the future value when the money finds use. Computing life cycle costs require determining the net present value of each alternative.

    An expenditure stream diagram provides for a graphical illustration of a design alternatives initial and future activities, agency and user costs associated with such activities, the timing of such activities, and costs. This makes the task of identifying costs to calculate net present value easy.

    The two approaches to identify the Net Present Value of future spending are a deterministic approach and a probabilistic approach. The deterministic approach assigns a fixed and discrete value to each variable based on the historical evidence or professional judgment of the analyst. This is a simple and straightforward, albeit a subjective approach. The probabilistic approach is more complex, and entails developing a sampling distribution of possible values for each input parameters through random draws from probabilistic distributions.

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    Determining the present value of all the expenses for each alternative allows for a direct comparison of the costs associated with each alternative. The ideal alternative will have the lowest present value. Selection of an alternative, however, may also depend on the preferred risk level, which means considering the level of uncertainty along with the lower present value. Application of sensitivity analysis identifies variables most significant in influencing the LCCA results.

    A Life Cycle Cost Analysis helps to identify the lowest cost option, but does not accommodate many considerations such available budgets, political and environment considerations, possible diversification, and other factors crucial when deciding among various alternatives. It provides critical information that aids decision-making, but remains incomplete to make a decision unless costs remain the only criteria of consideration.

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    • H Paul Barringer, P.E. "A Life Cycle Cost Summary." Retrieved June 24, 2011.
    • Carnegie Mellon University. "Life-Cycle Cost Analysis Primer." Retrieved June 24, 2011.
    • Sieglinde Fuller. "Life-Cycle Cost Analysis (LCCA)." Retrieved June 24, 2011.

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