Management Accounting-Performance Evaluation: Bob Scarlett Explains the Concept of Life-Cycle Costing and Discusses Its Applications in Investment Decision-Making and Financial Control

By Scarlett, Bob | Financial Management (UK), December 2007 | Go to article overview

Management Accounting-Performance Evaluation: Bob Scarlett Explains the Concept of Life-Cycle Costing and Discusses Its Applications in Investment Decision-Making and Financial Control


Scarlett, Bob, Financial Management (UK)


[ILLUSTRATION OMITTED]

The idea behind life-cycle costing (LCC) is simple enough. When calculating the cost of some activity--for example, developing a new product or installing a new IT system it's important to consider not only the initial cost but also the total cost to be incurred over the lifetime of that product or system. The lifetime cost is likely to include equipment maintenance, the replacement of parts, staff training, system upgrades and so on. The cost of doing anything is rarely a one-off, up-front expenditure. More commonly, undertaking some action involves a continuing commitment over the whole life of the action and its outcome.

LCC is a financial concept that has applications in strategy, decision-making, performance evaluation and management control. It forces managers to face the full consequences of actions that they have undertaken or are considering. In common with most other modern management techniques, it has been criticised. For example, Jim Seymour wrote in PC Week (September 1989) that LCC was being "used by hardware and software vendors ... as a kind of now-you-see-it, now-you-don't sophistry to 'prove' that something that looked outrageously expensive wasn't really so pricey after all". But the wider view is that assessing what something truly costs other than on a life-cycle basis is a fiction.

The following simple example shows how LCC analysis can be applied to decision-making. Consider the purchase of a new truck, which will be required to travel 50,000km a year. Two suitable models are available: the Trubrit and the Kamikaze. The Trubrit is priced at 36,000 [pound sterling] and has a life of six years. Its running costs are 15p per km in the first year, rising by 3p per km in each successive year. The Kamikaze is priced at 20,000 [pound sterling] and will last four years. It requires a new engine costing 5,000 [pound sterling] to be fitted at the end of the second year and has running costs of 20p per km in year one, rising by 5p per km in each successive year. The "cost of money" is 12 per cent. Which truck should we buy?

This is an LCC analysis problem. Our decision may be guided by calculation of an annualised equivalent cost (AEC) for both options (see table, left). The AEC is an equal annual amount paid at the end of each year that gives the same net present value (NPV) as the cost profile for the option over its whole life-cycle. In the Trubrit's case, the option AEC is the NPV (80,231 [pound sterling]) divided by the six-year cumulative discount factor taken from annuity tables (4.111). In the Kamikaze's case, the relevant NPV (64,678 [pound sterling]) is divided by the four-year cumulative discount factor.

The key point to note here is that, although buying the Trubrit involves the greatest initial expenditure, it turns out to be the best option when the whole life-cycle costs of the two alternatives are considered.

This example illustrates the proposition that the initial cost of doing something is usually far less than the future costs that you must commit yourself to paying. With the Trubrit, you pay 36,000 [pound sterling] initially, but are then committed to paying a further 67,500 [pound sterling] over the next six years.

In the case of product design it is usual for 80 per cent of a new product's lifetime costs to be committed at the moment it leaves the drawing board--and that's before any actual production costs have been incurred. This gives rise to the saying that good design is cheap and the cost of bad design only becomes apparent late in a product's life cycle.

The truck example can also be used to illustrate the control dimension of LCC. In buying capital equipment and making other business decisions, the full cost of doing something is often properly controlled only at the point of the decision. After that point, control over costs rarely amounts to more than monitoring expenditure. For example, the running costs of a Trubrit may be submerged into the category of general overheads. …

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