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Life Cycle Costing Guideline

Version Date Issued Review Date Principal Contact Telephone

2.0 January 2011 January 2013 State Procurement Board 8226 5001

Contents

Overview ..............................................................................................................3 Object of the Act...................................................................................................3 What is Life Cycle Costing? ....................................................................................3 Benefits of Utilising Life Cycle Costing ....................................................................3 When to Undertake Life Cycle Costing ....................................................................4 How to Undertake Life Cycle Costing ......................................................................4 Limitations of Life Cycle Costing.............................................................................6 Further Information and Resources ........................................................................7 Related Policies and Guidelines ..............................................................................7 Attachment 1 Example of a Life Cycle Costing Analysis .........................................8

Life Cycle Costing Guideline Version 2.0

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Issue Date: January 2011 Review Date: January 2013

Overview
This guideline provides information and practical advice in relation to the application of life cycle costing (LCC) to the procurement of goods (and related services). In reading this guideline, procurement practitioners will gain an understanding of: what LCC is; the impact of LCC on procurement decisions; the benefits of applying LCC; when and how to undertake LCC analysis; and the limitations of applying the LCC methodology.

Object of the Act

The object of the State Procurement Act 2004 (the Act) is to advance Government priorities and objectives by a system of procurement for public authorities directed towards: a) obtaining value for money in the expenditure of public money; b) providing for ethical and fair treatment of participants; and c) ensuring probity, accountability and transparency in procurement operations. The application of LCC must have regard to, and be consistent with, these objectives.

What is Life Cycle Costing?

LCC is a methodology for identifying and calculating the total costs and expenses associated with the purchase of goods, related services or integrated projects. This includes all initial and future costs related to the entire life cycle, including design, planning, acquisition, installation, operation, maintenance, refurbishment and disposal costs.

Benefits of Utilising Life Cycle Costing

The acquisition cost of goods has historically been the key factor influencing procurement decisions, with future costs sometimes ignored. In reality however, the immediate costs may represent only a small component of the total costs incurred over the entire life of the procurement. In some cases, operating and maintenance costs may comprise the majority of total life cycle costs. It is common for goods to have differing cost patterns or elements. For example, some goods may have a higher energy consumption rating, require a lower frequency of servicing or have more expensive costs associated with their disposal. LCC analysis identifies the pattern of these anticipated costs, enabling a more effective and informed procurement decision to be made. Undertaking LCC analysis results in a more comprehensive assessment of value for money, consistent with the object of the Act. Applying the LCC methodology allows procurement practitioners to: forecast future costs; understand the factors that drive costs (including hidden costs); evaluate competing options when undertaking a procurement; assess future resource requirements (i.e. budget implications); assess at which point a good will reach the end of its economic life; and improve operational support for a good during its economic life.
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The Australasian Procurement and Construction Council (APCC) also identifies and promotes the benefits of undertaking LCC when procuring goods and related services. The APCC notes in the context of value for money, products and services which have lower environmental impacts across their life cycle compared with competing products and services should be preferred. Encouraging a life cycle (or total cost of ownership or whole of life) costing approach to quantify the total cost of procuring products complements the objectives of this Life Cycle Costing Guideline.

When to Undertake Life Cycle Costing

Public authorities are encouraged to consider LCC analysis as an important tool in evaluating differing procurement options, depending on the nature and value of the procurement being considered. LCC is particularly applicable to high value/high complexity procurements and may be applied to low value/low complexity procurements when competing procurement options have markedly differing cost structures or usage patterns. Examples of procurements to which organisations have applied life cycle costing include complex equipment such as medical imaging systems and weapon systems, large scale engineering projects such as generators and pumping systems, and other goods such as photocopiers and vehicles.

How to Undertake Life Cycle Costing

The four key steps in calculating the life cycle costs of a proposed procurement are to: develop a plan; identify the cost elements; create a cost structure; and discount the future costs.

Each procurement or project will have its own unique features and level of complexity and each LCC plan should be customised to suit the particular circumstances of the procurement. The Australian/New Zealand Standard Life Cycle Costing An Application Guide (AS/NZS 4536:1999) outlines this process in more detail. Public authorities are required to maintain appropriate documentation to support evaluation decisions made utilising LCC analysis. 1. Develop a Plan The first step in undertaking LCC analysis is to develop an LCC plan, commensurate with the value and complexity of the goods being procured. This LCC plan will, amongst other considerations: define the expected outputs and outcomes of the proposed LCC analysis; delineate the scope of the proposed LCC analysis; and identify any underlying conditions, assumptions, limitations or constraints.

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Issue Date: January 2011 Review Date: January 2013

2. Identify the cost elements This guideline adopts the use of five cost categories, each comprising individual cost elements. These cost categories are: Acquisition costs the initial cost of obtaining the completed goods, including the purchase price, design, planning, freight, installation and initial training costs; Lifetime operating costs the costs (excluding maintenance costs) incurred during the life of the goods, including energy consumption, safety, contract and supplier management, and insurance; Lifetime maintenance costs the costs incurred in maintaining the dependability of the goods during their life, including performance management, consumables, spare parts, minor repairs or labour; Disposal costs the costs of removing or disposing of a good after its economic life has ended, including costs to decommission, dismantle, transport, dump or transition; and Residual value the expected value of the good at the time it is sold or disposed of.

Each cost category contains a number of individual cost elements. Cost elements influence or determine the total costs over the life of the goods. These elements can be identified and estimated from sources including an analysis of historic data or previous usage patterns, the opinion and advice of experts or industry sources, or advice and data from manufacturers or suppliers. Each cost element must be clearly defined, with an estimated dollar value, for a defined number of years in which the costs are expected to occur. The amount of time spent on estimating the cost and frequency should be commensurate with the size, risk and complexity of the proposed procurement. When identifying the cost elements, anticipated costs relating to the procurement must be included, such as any automatic cost of living increases or indexed costs that potentially impact on the cost of the procurement over its life. For example, if the maintenance costs for a particular procurement are scheduled to increase by a predetermined 5% per annum, this should be reflected in the cost structure. 3. Create a cost structure Once all key cost elements have been identified against each cost category, they can be placed into an LCC structure. An example LCC structure, for the purchase of a new hot water unit, is provided as Attachment 1. In this example, two competing hot water units are being considered, Option A and Option B. This example demonstrates the principles involved in establishing a cost structure. It is recognised that actual procurements and projects are often more complex than illustrated in the example and that the structure may need to be customised to suit the particular procurement being considered.

Life Cycle Costing Guideline Version 2.0

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Issue Date: January 2011 Review Date: January 2013

4. Discount the future costs Procurement related costs are generally incurred over the defined life of the goods (e.g. 7 years). While the majority of acquisition costs are generally incurred in year 0, operating and maintenance costs usually extend into the future. In the example provided in Attachment 1, the purchase price and installation costs are included as an initial one off cost, with other costs, such as service costs and energy consumption, occurring annually until the end of the estimated life of the goods. In general, a dollar spent in the future is worth less than a dollar spent now. Discounting these anticipated future costs requires the application of an appropriate discount rate (eg 10%) and enables all costs to be reflected back to their present value (known as Net Present Value or NPV). Discounting future costs to an NPV allows meaningful comparison of competing purchase options with different future cost profiles. As a rule of thumb, the discount rate is usually a combination of the current long-term expected interest rate minus the current long term expected inflation rate. However, it is important that specialist financial advice be sought before a particular discount rate is adopted. The relevant agency assigned Account Manager from the Finance Branch, Department of Treasury and Finance can provide an indication of the appropriate discount rate applicable for the period being considered. The discount rate used for the purposes of illustrating the case study in Attachment 1 is 10%. Each cost from year one to six has been discounted according to the number of years that will have elapsed since year 0. See Attachment 1 for a description of how this is calculated. As indicated by comparing Option A and B, the cost structure and the effect of discounting enables a meaningful comparison between the two options to be made, regardless of the varying costs. In summary, the example shows that although the initial purchase price of Option A is less than Option B, taking into account the total life cycle costs indicates that Option B presents greater value for money. For the purpose of approving procurement acquisition plans and purchase recommendations (including submissions to the Board), the actual proposed expenditure of the procurement (including the value of any extension options) is to be adopted, not the NPV. The scope of this guideline does not preclude consideration of more complex evaluation methodologies, such as, for example, sensitivity analysis and Equivalent Annualised Value (EAV). The Australian/New Zealand Standard Life Cycle Costing An Application Guide (AS/NZS 4536:1999) outlines these options in greater detail and is a useful supplement to this guideline, especially when undertaking LCC analysis for more complex procurements.

Limitations of Life Cycle Costing

It is important to recognise that there can be limitations or constraints to the application of LCC methodology. While it is relatively simple to establish the acquisition cost of a good, it can be more difficult to estimate the operational and maintenance costs that will be incurred during its life. Similarly, choosing the correct discount rate can be equally contentious. Consideration should also be given to any likely cost increases that may occur over this period.
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The use of objective research, historical data, and the opinions of relevant experts, including industry sources, manufacturers and other users, can assist in minimising uncertainty and risk, providing more accuracy in the costs identified. Undertaking an LCC analysis may involve considerable time and effort and analysis should be commensurate with the nature and value of the procurement, so that the benefits outweigh the costs involved. It is also important that the identified costs for each year of the cycle be matched to the budget provided before any particular option is chosen. In some cases, different options will have budgeting implications beyond the initial purchase price. These must be considered before a supplier is chosen and recommended for approval.

Further Information and Resources

For feedback or assistance regarding this guideline, please contact:

State Procurement Board Secretariat Department of Treasury and Finance ph: (08) 8226 5001 fax: (08) 8226 5667 email: stateprocurementboard@sa.gov.au www.spb.sa.gov.au

Related Policies and Guidelines

SPB Acquisition Planning Guideline AS/NZS 4536:1999: Life Cycle Costing - An Application Guide Australasian Procurement and Construction Council Australian and New Zealand Government Framework for Sustainable Procurement

Life Cycle Costing Guideline Version 2.0

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Issue Date: January 2011 Review Date: January 2013

Attachment 1 Example of a Life Cycle Costing Analysis

Cost Element/Cost Category Totals ($000) Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6

Hot Water System Option A Discount Rate 10% (#1) Multiplier Rate (#2)
1 Acquisition Costs Purchase Price Installation 2 Lifetime Maintenance Costs Annual service Programmed maintenance 3 Lifetime Operating Costs Energy Consumption 4 Disposal Costs Removal of Unit 5 Income from Residual Value (#3) Scrap metal value only TOTALS Net Present Value (1) 107
(#5)

1.0 45 5 45 5

0.91

0.83

0.75

0.68

0.62

0.56

28 6

4 6

14 10

2 10

(1) 56
(#4)

6
(#4)

12
(#4)

6
(#4)

6
(#4)

6
(#4)

15
(#4)

92.12
(#7)

56
(#6)

5.46
(#6)

9.96
(#6)

4.5
(#6)

4.08
(#6)

3.72
(#6)

8.4
(#6)

#1 A discount rate of 10% has been used for this example. Advice must be sought from the Finance Branch, Department of Treasury and Finance to determine the appropriate discount rate for each procurement. #2 Year 0s multiplier rate is 1. Each subsequent years multiplier rate can be calculated as follows: f = 1/(1+dr)^y where: dr = the discount rate per year (expressed as a decimal percentage) ^y = raised to the power of the year being considered (year 1=1, year 2=2 etc) #3 The residual value amount is treated as a negative for the purpose of calculating the total. #4 Individual totals are calculated by adding up the amounts for each item listed in the row above. #5 The total is calculated by adding up each of the individual yearly totals. This total can be validated by adding up the amounts for each item listed in the row above. #6 Individual NPV amounts are calculated by multiplying the individual year total by the multiplier rate (e.g. 12 x 0.83 = 9.96). #7 The NPV total is calculated by adding up each of the individual yearly totals.

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Issue Date: January 2011 Review Date: January 2013

Cost Element/Cost Category

Totals ($000)

Yr 0

Yr 1

Yr 2

Yr 3

Yr 4

Yr 5

Yr 6

Hot Water System Option B Discount Rate 10% (#1) Multiplier Rate (#2)
1 Acquisition Costs Purchase Price Installation 2 Lifetime Maintenance Costs Annual service Programmed maintenance 3 Lifetime Operating Costs Energy Consumption 4 Disposal Costs Removal of Unit 5 Income from Residual Value (#3) Scrap metal value only TOTALS Net Present Value (1) 96
(#5)

1.0
58 10 58 10

0.91

0.83

0.75

0.68

0.62

0.56

14 3

2 3

7 5

1 5

(1) 71
(#4)

3
(#4)

6
(#4)

3
(#4)

3
(#4)

3
(#4)

7
(#4)

88.78
(#7)

71
(#6)

2.73
(#6)

4.98
(#6)

2.25
(#6)

2.04
(#6)

1.86
(#6)

3.92
(#6)

Life Cycle Costing Guideline Version 2.0

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Issue Date: January 2011 Review Date: January 2013