What is life cycle costing in accounting?

Life cycle costing is a method of adding up all the costs associated with an asset starting from its initial cost to its
end of life. It does not take into account the salvage value or residual value of the asset. Life cycle costing
provides an estimate of the cost that an asset will incur in its lifetime. Life cycle costing calculation generally
involves adding six types of costs; purchase costs, maintenance costs, operational costs, financing costs,
depreciation costs, and end-of-life costs. The summation of these costs gives the life cycle costing value. In some
cases, the costs won’t apply to the asset in question and so they are not part of the calculation.

Life cycle costing can be highly beneficial to businesses of all types and sizes. It gives a realistic estimation of
costs over the course of a product's life. Generally, businesses have the tendency to buy products that have a
lower upfront cost. However, with time, the maintenance costs, operating costs, and recurring costs can add up.
When these add up, the product can be much more expensive than the one that has a higher upfront cost but a
lower recurring cost. Life cycle costing is a time-consuming process but it can uncover costs that can ease the
decision-making process

How to use life cycle costing?

Life cycle costing in accounting enables you to plan efficiently and cut costs along the way. It is used by
businesses that are involved in long-term planning. Life cycle costing enables businesses to make better decisions
with regard to their investments. If there are two assets you are considering, calculating the life cycle costing of
the two assets can unveil which asset is more profitable in the long run. In this way, you can spend your money in
the right places. Life cycle costing makes budgeting easier. For example, if you do not know the expenses that
will be incurred, you won’t be able to make a reliable budget. With life cycle costing budgeting is more precise.

Let us explore the use of life cycle costing in different areas. In the engineering industry, life cycle costing aids in
the development and manufacturing process of the products. These products are made such that they do their job
but aren’t too expensive for the customer either. That is the total lifetime cost of the product isn’t a burden to the
customer. In the procurement area, businesses will consider life cycle costing to determine which products they
should buy and which they should avoid. They will look for items that are cheap to maintain and operate.
In capital budgeting, life cycle costing can be used to figure out the ROI which aids in the purchase decisions.

Life cycle costing is mostly used for tangible assets. However, it is applicable to intangible assets too. For
example, a business patent. While the costs may be trickier to add up in the case of intangible assets, it is possible
to calculate the value of life cycle costing. For example, patents cost money. They require that you hire a
knowledgeable individual such as a lawyer. You need to pay for the patent maintenance and so on. When you add
all of these costs up, you can come up with the life cycle costing value. In this way, life cycle costing has
numerous applications in all aspects of business expenditure.

Life cycle costing process

The Life cycle costing process consists of three major stages. The first stage is developing a plan that will aid in
decision-making. It involves determining the objectives such as determining what different options mean for the
business. The second stage is the analysis stage which helps with cost control and management. It involves
setting targets that can change later on due to precise estimation from other assets that work similarly. The third
stage is the implementation and monitoring stage. In this, the performance is implemented and monitored to
determine if additional cost savings are possible. This activity can be useful for future investments in assets and
planning.

Purpose of life cycle cost analysis

The life cycle cost analysis has the following main purposes.

Cost identification
The purpose of life cycle cost analysis is to identify all types of costs that a business may not think of in the
initial stages. Businesses might be tempted with a lucrative offer without realizing that over time the costs
surpass the offer pretty quickly. Life cycle cost analysis throws light on whether profits can recover the costs
incurred at different stages of a product’s life cycle. Rather than compare individual costs, a cumulative
comparison of the options is possible by first identifying all the costs related to the asset or product.

Costs comparison

Another major purpose of Life cycle costing is cost comparison to make effective decisions that can prove
fruitful in the long term. Businesses can choose to invest as they wish depending on how much they are willing to
spend. When they have various options, it makes sense to compare the costs that will be incurred to make smarter
decisions. Let us say product A has a lifetime cost of $500 while product B has a lifetime cost of $650 even
though they perform the same function. Comparing costs enables businesses to decide which is the more cost-
effective option from the options available. This can maximize profits.

Effective planning

Life cycle costing aids in planning. A business can effectively plan when it is aware of the various costs involved.
For example, let us say a product’s initial costs are extremely high, it has a lifetime of 10 years, and the
maintenance costs are low. With life cycle costing, a business is aware of all these costs and so it can plan budget
allocation accordingly. Additionally, it uncovers when a product needs a higher investment in comparison. For
instance, if a product needs higher investment during the operational phase, then a business is better prepared to
invest and spend at that time. Without life cycle costing, expenditure planning is tougher although possible.

Life cycle costing assessment example

Let us take a simple example of equipment to explain the life cycle costing assessment and how it works.

Particulars Value
Purchase cost 10,000
Installation cost 500
Operating cost 3,000
Maintenance cost 1000
Depreciation value 500
Disposal value 1000
Life cycle costing 16,000
The initial investment to buy the equipment is 10,000 for the purchase while the life cycle cost turned out to be
16,000.
 Life Cycle Cost is defined in the AWWA Asset Management Definitions Guidebook as “A methodology
that provides an estimate of the total capital, operating, and maintenance costs of an Asset over its
operating life. Relevant costs include planning, design, acquisition, installation, maintenance,
Rehabilitation, financing, retirement/ decommissioning/ disposal and any other costs directly
attributable to operating or using an Asset.”
Life Cycle Costing, in accounting terms, is the process of compiling all the costs the asset will incur
over its lifespan. These costs include the initial investment, future additional investments, annually
recurring costs, and salvage or disposal costs. Managing the life cycle of the assets helps to expand
their ability to serve for as long as possible. The information collected about the assets allows systems
to better understand at what point in the asset’s life it currently stands, which increases system
efficiency and Level of Service.
Life Cycle Costing is an important concept in asset management because it allows the system to place
an emphasis on holistic, long-range costs. An organization that does not pay attention to Life Cycle
Costing can only optimize the immediate purchase cost and does not have the ability to fully
understand costs that will need to be expended during the time the asset is in service, including all
operation, maintenance, repair, monitoring, and rehabilitation costs. Ignoring “opex” (operating
expenses) while focusing only on “capex” (capital expenses) puts a utility in a compromised position
and prevents the utility from optimizing its life cycle cost. A system that selects a particular option might
find the replacement of parts is more expensive than it thought or requires additional operator training
or an increased staffing level. A few examples from systems around the U.S. are presented below.
 A small drinking water system that installed an adsorption system for arsenic treatment only to find out
the media needed to be replaced every 6 months, rather than every 2 years, at a cost of $35,000 each.
 A medium sized drinking water utility that was provided a water system that needed to be operated
with in-person operators 24/7/365, instead of its previous operating schedule of day shift operators
only.
 A large wastewater system that discovered that a replacement part for its disinfection unit was
available only from Germany. The part was extremely expensive to replace.

It is critically important during this component of asset management to examine the overall life of the
asset and the costs associated with each component of that asset’s life. It is also important to
understand the assets’ role as a part of the collective. Life Cycle Costing is the intersection of asset
management and managing assets. Life Cycle Costing requires strategically managing the entire
system while also considering the most effective and efficient management for each individual asset as
it proceeds through its life. Life Cycle Costing is where strategic asset management – making
decisions about the collective set of assets – meets managing assets – making individual decisions
about each asset. Both aspects are important to a well-run, efficient, and effective system, and it is
important to understand the difference between them.
Optimal asset Life Cycle Costing requires the use of historical data such as condition, performance,
maintenance, risk, and cost. Therefore, data must be collected and utilized to drive the decision
making of the system. Think about where existing data can be found and where future records should
be kept.
The phases of an asset’s life cycle include every time a decision or expenditure is made related to the
asset. Therefore, it is important to recognize that an asset’s life starts long before it is put into
operation. The beginning of the asset’s life is when it is first contemplated as part of planning or
conceptual design. The next part of an asset’s life cycle is design. Once design is complete, the next
phase is construction or installation. Once the asset is installed, it is ready for operation. The next
phase of the asset’s life includes the maintenance activities (all types of maintenance, except
corrective which is covered in the next phase under repair). If and when the asset fails, the next three
stages of the asset’s life come in: Repair, Rehabilitation and Replacement. Which of these activities
occurs depends on the nature of the asset failure and many other factors. It is also possible for an
asset to experience all of these at some point during its overall life. At some point, the asset will no
longer be in service and will undergo its last life cycle phase – decommissioning or disposal.
Throughout the asset’s life, it is necessary to have sufficient funding to allow the asset to provide the
required level of service. Without sufficient funding, it might not be possible to intervene as needed
during the asset’s life, and the asset might fail prematurely, reducing the overall cost efficiency.
The risk analysis is foundational in the decision-making for asset operation and maintenance and in
determining when to repair, rehabilitate or replace a given asset. The risk analysis identifies assets that
are high, moderate, and low risk. Basing decisions regarding operation and maintenance intervention
on asset criticality allows the system to optimize limited funding. Risk can also guide the decision-
making process in terms of repair, rehabilitation, and replacement. In general, lower-risk assets and
those that are moderate risk based on a high probability of failure and a low consequence of failure,
can run to failure and be repaired after the failure. High-risk assets are likely to be replaced early,
before a failure occurs, to prevent the negative consequences from happening. Moderate risk assets
(based on high consequence but low probability) can be monitored to determine when a failure might
be likely to occur, and then the system can rehabilitate or replace the asset prior to the failure. These
actions are broad generalizations; the repair/rehabilitate/replace decision can be made for each asset
individually based on cost, technology, underlying condition of the asset, type of consequence and
many other factors.
Understanding the assets’ life cycle allows for the development of Long Term Plans such as Capital
Improvement Plans. Life Cycle Costing allows the system to look longer term and plan for the financial
need to replace assets. The asset replacement should be included in a Capital Improvement Plan.
Life Cycle Costing allows the system to think about assets individually and collectively. With the data
and knowledge gained through the previous core components of asset management, systems can
determine the best strategy for the assets, both individually and collectively, to meet the desired Level
of Service at the optimal Life Cycle Cost.
Robust Life Cycle Costing strategies and decision-making take time to develop, including collecting the
data and analyzing it. However, systems can make progress in the early stages by beginning to
question existing maintenance practices to determine what is being done because it has always been
done that way rather than because it is the optimal way to do the maintenance activity.
Another question to ask is whether the maintenance activity has a role in meeting the Level of Service.
Making revisions in practices can impact optimizing costs and personnel time. Life Cycle Costing
involves many facets within the organization at different points in the asset’s life, which provides an
opportunity to involve a wide audience.
Green Infrastructure is in the early phases of tracking data to enable a roust Life Cycle Costing
analysis. It might not be possible at the beginning of implementing a green/gray (or just green) asset
management program to implement full Life Cycle Costing strategies, but similarly to the discussion
above there are opportunities to begin the process of improving Life Cycle Costing practices right
away. Over time, as green infrastructure practice matures, it will become easier to implement Life
Cycle Costing strategies. In the early 2000s, gray infrastructure was in the early phases of Life Cycle
Costing and had similar needs to develop the data. But now, in the early 2020s, much progress has
been made. This evolution is fully expected for green infrastructure as well. The details will come as
the infrastructure ages and grows.