Life Cycle Costing

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What is Life Cycle Costing?

Life Cycle Costing is a method that aggregates all costs that an organization or individual will incur over the life span of the asset, project, investment, etc. It includes the initial investment (non-recurring expense) and any further investment such as operating cost, maintenance, repair, and upgrades (recurring expense).

Life cycle costing is also known as whole life costing. Its primary purpose is to help management decide whether or not to go ahead with a project or acquire an asset. Management usually analyses the cost of ownership and operating cost and then eventually chooses the asset with the minimum overall cost.

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Process

We can break down the life cycle costing process into the following cost heads – initial investment, recurring cost, disposal cost, and residual value.

Life Cycle Costing
  • Initial Cost: It is either the purchase price of an item or the initial cost of the set-up in case of a project. In most cases, it also includes the cost of installation.
  • Recurring Cost: It represents all those costs that take place after the purchase, which primarily include operating expense and maintenance expenses.
    • Operating Cost: These costs are associated with the usage of the asset.
    • Maintenance Expense: These costs are associated with repair and replacement expenses.
  • Disposal Cost: These costs are incurred at the time of asset disposal.
  • Residual Value: It represents the asset's value at the end of its useful life. The higher the residual value, the lower the asset's whole life cost.

Formula

We can derive the value of whole life costing by identifying all the cost heads and their corresponding period of occurrence, then discounting them to the present value, and then adding them up while deducting the present value of the residual value. Mathematically, it can be represented as,

Life Cycle Costing Formula = Initial Cost + PV of All Recurring Costs – PV of Residual Value

Example of Life Cycle Costing

Let us take the example of John, who wants to purchase a new car worth $12,000. Calculate the car's life cycle cost if John plans to sell the car after five years at a residual value of $3,000. As per estimates, the annual expense for maintenance & repair will be $1,000, and gas consumption per year will be another $3,500. Please consider the applicable interest rate to be 8%.

Given,

  • Initial cost = $12,000
  • Recurring cost = Maintenance & repair + Gas consumption
  • = $1,000 + $3,500
  • = $4,500
  • Residual value = $3,000
  • No. of years = 5
  • Interest rate = 8%
Life Cycle costing Example 1

Now, life cycle costing of the car can be calculated by using the above formula,

Life Cycle costing Example 1-1
  • = $12,000 + $4,500 * / 8% - $3,000 / (1 + 8%)5
  • = $27,925

Applications of Life Cycle Costing

  • In capital budgeting, the life cycle costing is a critical component of the decision-making process (purchase of asset) as it is used to estimate the net cash flows and the expected return on investment (ROI).
  • In the case of procurement, the department uses it to determine which is the least expensive item and accordingly place the orders.
  • In engineering and production, this concept is used in developing and manufacturing goods that incur the least cost to the customer in terms of installation, operating, maintenance, disposal, etc.
  • In the case of customer service, whole life costing is used to minimize the amount of replacement, warranty, and field service.

Benefits

  • It provides a precise estimate of the expected cost to be incurred over the asset's life span.
  • It makes sure that the best decision is made based on an accurate and realistic estimate of costs.
  • It ensures that the management takes early actions to lower recurring and non-recurring costs.

Effects

The life cycle costing estimates help decision-making where a mutually exclusive option is available. Also, the management can plan to reduce the item's overall cost through the extension of useful life, efficient utilization, or other similar cost rationalization measures.