Moneyspeak

Facilities Check List
Practical, step-by-step guides for the busy FM
August 1998

Moneyspeak

As a facilities professional, you’ve likely assumed some — if not all– of your department’s financial reporting responsibilities. Handlingbudgets and justifyng facilities expenditures are part of nearly everyfacilities manager’s job. To help you understand the many different waysto analyze an investment, we present a summary of the investment analysistools most often used for facilities-related projects.

Lowest First Cost

Lowest first cost is the most often used investment tool because it is thesimplest to understand: find the lowest-priced item that meets yourspecification at your time of need and choose it. It is an excellent choicefor the following circumstances:

• When many vendors supply the commodity you need and most brands areidentical in all major respects
• When there are many vendors in competition in a fairly stable market,thus ensuring a steady source of supply
• When substitutions of one brand for another can be made easily
• When an item can be precisely specified in definitive terms
• Where the economic life cycle of the desired item is very short ornon-existent
• If there are no maintenance or operating costs

There are many situations that lowest first cost cannot address. Forexample, if quality varies from one item to another, lowest first costcannot be relied on to provide satisfactory results.

Life Cycle Cost Analysis

Another investment tool that fms should understand is life cycle costanalysis, which accounts for all costs and returns associated with an itemover its entire (economic) life cycle, including associated personnel,energy, maintenance, replacement, and other costs affected by theinvestment. There are four major cost categories in a life cycle costanalysis:

• Initial costs of acquisition of the asset: purchase, design, delivery,installation, testing, reconstruction, moving, etc.
• Ongoing expenses such as utility, servicing and maintenance costs,which continue throughout the life of system operation.
• One-time future expenses, such as system calibration after commencingoperation, major upgrades or overhauls, which will occur infrequently andpredictably during the life of the asset.
• Any salvage value obtained when the asset is retired

This approach works best to compare the total lifetime cost of severaloptions for solving a problem. Thus, this approach is valid for investmentswhere long-term payback is a major factor. The shorter the asset life, theless valid this method becomes.

Complex or compound assets, such as energy management systems, can only bejustified by using life cycle costing. The use of an energy managementsystem is a cost that is added to standard electrical and mechanicalequipment costs. The only method to justify the additional cost is toquantify the savings which are produced in associated areas. Energymanagement systems and other such products produce cost avoidance or costsavings after the payback period (explained below).

Cost Benefit Analysis

Cost benefit analysis addresses the question, “Are the benefits of aproject worth its costs?” It is useful for projects that involve physicalimprovements to tenant space that do not affect the market or asset valueof the property as a whole. It can even be used to support trade-offsbetween cost-related and qualitative factors. It should not be confusedwith life cycle cost analysis, in which costs are assessed over aninvestment’s useful life, but not against its benefits.

Cost benefit analysis is the method of choice if you must comparequantifiable/measurable or “hard” factors or costs (those associateddirectly with actual construction, leasing, maintenance and upkeep) andqualitative or “soft” factors (those related to the management ofconstruction, leasing, maintenance and upkeep, such as overhead, fees, andmanagement time). Quantifiable issues most often boil down to costs orsavings (avoided costs). However, not all quantifiable issues relate tocost — for example, comparing performance capabilities and characteristicsof two computers.

Payback

When a physical asset is part of a larger capital project, the organizationexpending money for that asset expects to be “paid back.” The most obviousquestion is “When will that happen?” This recouping of funds used in theoriginal investment is called the payback period. Stated another way, asimple or discounted payback period is the time period after whichaccumulated savings, net of other accumulated costs, offset the initialinvestment cost.

Payback is a form of break-even analysis, which holds that if a projectcontributes any return greater than variable costs, the project should beundertaken. Such an approach ignores capital investments and the time valueof money (unless discounting the savings takes into account the time valueof money as discussed in “Present Value” below). Payback can also becalculated by determining the life cycle costs and/or thesavings-to-investment ratio, translated into net present value terms.

Payback can also be increased as a result of cost reduction. Expectationsfor the payback period range across the board for organizations. Since thepayback period depends on generation of net cash flow, the decision ofrequired payback period is extremely product- and organization-specific.

Frequently, there is a close correlation between quality and slowerpayback. The shorter the permitted payback period (the time needed torecover the initial investment), the more likely quality must becompromised. The flip side of the coin is that as quality is compromised,durability decreases and maintenance costs increase. The cheaper somethingis to buy, the sooner it will deteriorate and the more it will cost tomaintain.

This technique is particularly useful in the following situations:

• To evaluate small investments that do not merit in-depth study oranalysis
• To screen small investment proposals before a formal request forexpenditure is prepared
• Relevant information on the timing of cash returns from an investment

Net Benefit or Savings (NB)

A variation on break-even analysis, this tool finds the difference betweenthe lifetime dollar savings and lifetime dollar costs of a facilityinvestment. Net benefits or savings may be expressed in either presentvalue or annual value dollars. Net benefit or savings shows how much lessthe asset will cost to operate after the new solution has been installed.

Savings-to-Investment Ratio (SIR)

In this method, savings and investment costs are expressed as a ratiorather than a dollar amount. The higher the ratio, the more dollar savingsrealized per dollar of investment. This method is useful for comparinginvestments of relatively similar scope to determine which will yield the”biggest bang for the buck.” It provides the level of expenditure vs. theamount required to make the change.

Present Value

To compare costs on an equal basis, all cash flows are generally convertedto their present value — that is, the value of past and future dollarscorresponding to today’s values. The premise behind the concept of presentvalue is that the value of money changes over time, that money now is worthmore than money in the future and less than money in the past. The timevalue is tied to the interest that money makes, or could have made, if cashtransfer were deferred to the future. The interest rate is known as thediscount rate and the process for converting to present value is calleddiscounting.

Another major reason for the requirement to convert dollars to presentvalue is that of inflation. As inflation occurs, the buying power of thedollar declines. The value of the dollar becomes inflated and must bediscounted to indicate its real value or purchasing power.

Once discounted and summed over the economic lifetime, the present valuesof different investments can be compared since they are expressed on anequal basis in time. The investment having the lowest present value has thelowest life cycle cost.

Internal Rate of Return (IRR)

This is the interest rate for which lifetime dollar savings are just equalto lifetime dollar costs, after the time value of money is taken intoaccount. This percentage is then compared to the minimum corporate rate ofreturn to determine if the investment is desirable. Internal rate of returnis an organization-specific figure which provides a level of benefit reapedfrom making the investment.

This tool is frequently used to compare competing investment proposals,such as a chiller retrofit vs a new product launch. A capital-intensivecompany looking to maximize its investments may want to get the bestpossible return. The corporation establishes the stated return it desiresto achieve. IRR measures the actual rate of return of an investment and canalso generate how many dollars of return will be generated above thedesired rate of return.

Approaches and Methods Compared

Life cycle cost and net benefit techniques are best for finding theeconomically efficient size of an investment. If life cycle costs fall ornet benefits increase with added investment, it is profitable to increasethe investment.

By measuring the change in costs and the amount of savings resulting from afacility investment, life cycle cost and net benefit tools also answer thequestion: How much will overall costs be lowered?

Either tool will also answer the question: How can directly competingprojects for the same purpose be compared? For example, if total costs arelower with company-run dining versus a franchise, opt for company-rundining, other factors being equal.

On the other hand, life cycle cost and net benefit do not distinguishbetween large and small investments that result in the same net dollarsavings. Furthermore, they are not effective for comparing projects havingdifferent purposes and competing for a limited budget, or for projects thatcan be implemented simultaneously. This can happen when facilitiesproposals compete against other investment opportunities proposed by otherdepartments.

Life cycle cost and net benefit evaluate benefits in absolute dollar terms;whereas, savings-to-investment ratio (SIR) and internal rate of return(IRR) rank investments using relative measures of cash inflows and outflows.

Thus, unlike life cycle cost and net benefit, SIR and IRR reflect thereturn on the investment dollar and therefore can be used to rank projectsto determine those that result in the largest total return for a givenbudget. None of these methods takes into account the qualitative benefitsto employees associated with each of the schemes, i.e., the human factorsassociated with a project.

In the case where fast turnaround of investment funds is required, thepayback technique is recommended because it indicates the period necessaryto recover the funds. New mechanical equipment that can only be paid forout of energy savings from the operating budget is an example. If thepayback is less than a year, the project may gain approval without meetingthe normal investment hurdles. However, don’t overemphasize payback if thisputs less efficient, short-term investments over more efficient, long-termones. Payback doesn’t give the full picture, primarily because it doesn’tgive a clue about benefits and costs occurring after the payback date isreached. Supplement payback with one of the other life-cycle evaluationtools.

This article is based on BOMI Institute’s Fundamentals of FacilitiesManagement course, a requirement of the FMA designation program.