Life Cycle Costing

Matthijs Kok
Asset Lifecycle Activities
 Typical Life Cycle Cost Profile
cost
COST
DEVELOPMENT
COST
Planning
Design
Acquisition
Construction MAINTENANCE
COST
Staff
Equipment
Spare parts
OPERATION Repair
COST Training
Staff
Energy
Training DISPOSAL COST
Decommissioning

Asset life
Asset Life TIME
 Introduction
• Infrastructure: relatively long life times.

• In Capital Budgetting the time value of money plays an

important role.

• A dollar in hand today is worth more than a dollar to be

received next year. If you had it now, you could invest it,
earn interest, and end up next year with more than one
dollar.

• Life cycle costing: evaluation technique helping to choose

between competing alternatives.
 Life cycle costing process
• Comparing alternative investment decisions, a decision
maker will focus upon initial capital costs.

• However, spending a little bit extra in the initial

investment, may well reduce expenditures in the
future.
• The basic idea behind the life cycle costing technique is
to look at the balance between initial and future
expenditures of an investment project.

• Life Cycle Costing = Total Cost Approach

 Life Cycle Approach
• For each alternative the investments costs and all
expenditures during its entire life has to be
assessed.

• The first step ("generating investment

alternatives") is the most critical one.

• It depends upon the skills and creativity of the

design team. The technical, functional and
aesthetic requirements have to be defined
 Diagram
Generating investment
alternative

Determining the period of

analysis

Forecasting cash flows

Risk Analysis
Applying financial
appraisal techniques

Investment decisions
 Uncertainties
• Life cycle costing deals with the future, and the
future is unknown. All future cash flows are
estimates, no matter how reliable the data on
which they are made.

• None of these estimates can be made with

certainty. There is often some knowledge
regarding the reliability of the estimates.

• Risk and uncertainty do not imply ignorance (that

is: "we do not know").
 Financial appraisal techniques
There are four possible techniques:

• Payback Period (PP)

• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Benefit-Cost Ratio (BCR)

The Net Present Value (NPV) of a project is the synonym

of the project's Life Cycle Costs. The other appraisal
techniques are only presented for illustrating purposes. In
practice the NPV technique should be applied.
 Investment alternatives
If benefits of all alternatives are the same,
only costs (investments and Operation and
Maintenance) are relevant

Choosing between competing designs of

objects, all cash flows will be outflows (no
cash inflows, e.g. earnings).
In order to overcome this problem, an
incremental approach must be used.
 Payback period
Alternative Object A Object B B-A
Initial cost -100.000 -130.000 - 30.000
Cash flows
year 1 - 15.000 - 4.000 11.000
year 2 - 15.000 - 4.000 11.000
year 3 - 15.000 - 4.000 11.000
year 4 - 15.000 - 4.000 11.000
year 5 - 15.000 - 4.000 11.000

Payback
period 2,727 yr.

Drawback of PP method: it ignores all cashflows outside the

payback period.
 Net Present Value
Any acceptable appraisal technique should have two properties:

• All cash flows in the period of analysis should be taken into

consideration
• it must make proper allowance for the time value of money

The Net Present Value technique meet these properties.

The Present Value (Pn) of an individual amount of money Tn in n years

time with interest rate r is given by the equation:
 Question
Using r = 0.05, determine the Present Value of:

• T1 = 1000
• T5 = 1000
• T10 = 1000
• T25 = 1000
• T50 = 1000
• T100 = 1000

using the formula:

 Decision rule NPV
The alternative with the highest Net Present Value
should be selected:
Formula:
n
CF t
NPV = ∑ t
t =0 (1 + r )
with:
CFt is expected cash flow in year t, and n is the
period of analysis.
The present value is the sum of the discounted cash
flows of the project.
Interpretation of Net Present Value: it is the
today's price of the total investment
 Question

Determine the Net Present Value of the following

cash flows:
CF0 = 1000
CF1 = 50
CF2 = 50
CF3 = 50
CF4 = 50
CF5 = 50
r = 0.05
using the formula:
n
CF t
NPV = ∑
t
t = 0 (1 + r )
 Factor for annuity

The above formula can be simplified if we

have constant payments P:
 1 1 1 
Ar ,n = P  + + ... +
+ 2 n
 (1 r ) (1 + r ) (1 + r ) 

The term between brackets is the factor for

annuity, and can be approximated as:

 1 
1 − n

 (1 + r ) 
AFr ,n =
r
Projects with unequal life span
Consider the project L and S:
Alternative Project L Project S
Initial cost - 400.000 - 250.000
Cash flows
year 1 - 5.000 - 15.000
year 2 - 10.000 - 20.000
year 3 - 15.000 - 25.000
year 4 - 17.500 - 35.000
year 5 - 20.000 -
year 6 - 25.000 -
year 7 - 35.000 -
year 8 - 50.000 -
NPV (r=5%) - 534.226 - 332.816
Solution:
determine equivalent annual annuity of project L and S:
Project L: -534.226/6,46 = -82.657
Project S: -332.816/3,54 =- 93.857
 Internal Rate of Return (IRR)

The IRR is defined as that discount rate r which equates the

present value of a project's expected cash inflows to the
project's expected cash outflows.

PV(cash inflows)=PV(total investment costs)

or equivalently:

n
CF t
IRR = r: ∑ t
= 0
t = 0 (1 + r )
 Example
The IRR is rather well suited for evaluation, but is more
difficult to compute.

Alternative Project L Project S L-S

Initial cost - 400.000 - 250.000 - 150.000
Cash flows
year 1 - 5.000 - 15.000 10.000
year 2 - 10.000 - 20.000 10.000
year 3 - 15.000 - 25.000 10.000
year 4 - 17.500 - 285.000 267.500
year 5 - 20.000 - 15.000 - 5.000
year 6 - 25.000 - 20.000 - 5.000
year 7 - 35.000 - 25.000 - 10.000
year 8 - 50.000 - 35.000 - 15.000
IRR 18%
 Benefit-Cost Ratio (BCR)

The BCR of a project is the ratio of the present value of future benefits,
to the present value of the future costs:
n
CIF t
∑ t
PV benefits (1 + r)
BCR = = t=0
n
PV costs COF t
∑ t
t=0 (1 + r)
with: CIFt the cash inflows in year t and COFt the cash outflows in year t

This method van only be applied to difference between project

(otherwise there are no benefits)
 Risk and Uncertainty
Suppose that an investment project has three possible
future cash flow profiles:

The expected NPV (ENPV) is calculated by multiplying

the NPV of each scenario with the probability:
ENPV = -19.250. Scenario Optimistic Most Likely Pessimistic
probability 0,3 0,4 0,3
Initial cost - 10.000 -10.000 - 10.000
Cash flows
year 1 - 800 - 1.200 - 1.600
year 2 - 800 - 1.200 - 1.600
... ... ... ...
... ... ... ...
year 10 - 800 - 1.200 - 1.600
NPV - 16.177 - 19.266 -22.355
(k=5%)
 Sensitivity analysis
The ENPV is a very simplified approach. Other approaches in practice
are followed. For example, three different approaches can be followed:

• from an economic point of view

• from a statistical point of view
• sensitivity analysis

In this course only the Sensitivity Analysis will be handled.

The sensitivity analysis is defined as a technique that indicates exactly

how much the life cycle cost of an investment alternative will change
in response to a given change in an input variable, such as the interest
rate.
 Spider diagram
Steps:
• Calculate NPV of
investment project
• Identify the parameters
which are uncertain
% Variation
• For each parameter, the in parameter 2 2 3

NPV is calculated 1
1

assuming that the 5

3

parameters are varied by a

fixed percentage 2

0
• The final step is the A B NPV

construction of a graphic
interpretation, called a -5

spider diagram.
 Spider diagram
• The spider diagram does not indicate of the
likely range of variation of the risk parameters.
• By adding probability contours this weakness
can be overcome.
 Barriers of the Life Cycle Concept

1. Decision makers are preoccupied with initial capital cost

2. Life Cycle Costing uses estimates of future cash flows, and

these are uncertain

3. Organizational deficiency, since in the total cost approach

the investment- and maintenance costs are treated as an
integrated whole

4. Other factors than financial are also important in making

decisions, for example the desire to have the work
completed in short time
 Exercise
There are two alternatives:
Alternative A: initial costs of 800 M$, yearly
maintenance costs of 50 M$, and lifetime of 20
years;
Alternative B: initial costs of 500 M$, yearly
maintenance costs of 100 M$ and lifetime of 50
years.
Interest rate: 5%
Which alternative is cost-effective?
 Question

Determine the Net Present Value of the following

cash flows:
CF0 = 1000, CF1 = 50, CF2 = 50, CF3 = 50,
CF4 = 50, CF5 = 50
r = 0.05, using the formulas:

 1 1 1 
Ar ,n = CF  + + ... + 
 (1 + r ) (1 + r )
2 n
(1 + r ) 

 1 
and / or: 1 − n

 (1 + r ) 
AFr ,n =
r
 Question
Consider two alternatives for building a hydraulic structure.

The first alternative (A) has high investment costs and low maintenance costs. The second
alternative (B) has low investment costs and high maintenance costs.
The interest rate is 5%.
Which one is cost-optimal?

Alternative A:
• Investment costs: $ 100.000,-
• Maintenance cost: $ 1.000,- per year
• Lifetime: 50 years
•
Alternative B:
• Investment costs: $ 40.000,-
• Maintenance costs: $ 5.000,- per year
• Lifetime: 50 years