By Ir. Dr. John D. Gilleard, IFMA Fellow, The Sloane Partnership
I first came across the term “life cycle costing” in P.A. Stone’s influential book “Building Design Evaluation: Cost in Use”. That was almost 40 years ago and ever since I have been fascinated by the simplicity and objectivity of this financial tool. Stone defined life cycle costing (LCC) as “an economic assessment of competing design alternatives, considering all significant costs of ownership over the economic life of each alternative, expressed in equivalent dollars.” The rationale behind LCC is based on the time value of money, reflected in the interest rate banks offer for deposits and the interest rate they charge for loans.
Interest accrued on deposits and loans is a reflection that under normal periods of monetary inflation, a dollar in cash is worth less today that it was yesterday, and worth more today than it will be tomorrow. Hence, to compensate for this “loss” investors seek a financial gain in the form of a return on capital. For example, imagine you deposit $1,000 with the bank. For the use of your money the bank pays you interest of 10 percent or $100 at the end of one year. If we assume you leave both the capital (your original $1,000) and the $100 interest payment for an additional year, the return on your investment (now $1,100) would be $110. Clearly, “compounding” your investment attains a higher rate of return. Indeed, if you were to leave your original $1,000 for a longer period, say for 10 years, your eventual return would be $2594, quite an impressive sum. However, with this example the influence of inflation has been ignored.
Taking inflation into account, normal practice for private investors, then a “discount” rate of return is used to determine the return on investment.
Consequently, any investment with a return less than the annual inflation rate represents a loss of value, even though the return might well be greater than 0 percent. For example, assume you invest $1,000 with a Hong Kong bank paying an annual interest rate of 2.5 percent. Compounded over a five year period your total return would be $1,276. However, if we take Hong Kong’s current headline inflation rate into account, 5.4 percent , the discount rate of return would be -2.75 percent, resulting in a loss of purchasing power of -$130 from our original $1,000.
Time is money
Understanding that a dollar expended today is not equivalent to one spent at a future point in time is critical to LCC. Future spending is “discounted” to establish an equivalency of today’s expenditure, i.e. to its present value. Spend may be a single sum of money at a future period of time, or an annuity / recurring expenditure. To produce a LCC for a facility management or corporate real estate project it is necessary to establish the life of building / component / workplace; the initial capital cost; the cost and frequency of future payments, e.g. component maintenance, operation and repair, energy costs, replacement / refurbishment costs; financial charges such as loan interest rates and inflation; tax implications; and finally salvage values. The results of an LCC analysis can then be used to assist management in the decision making process where there is a choice of options.
As an illustration, you have estimated that the CAPEX for an energy conservation project is $2,000,000, resulting in an annual cost saving of approximately $200,000 a year for the next 20 years. You also assume a discount rate of 10 percent. Given these figures would you recommend going ahead with the project? This is a typical LCC question, and one quickly resolved by calculating the present value of the recurring cost savings against the initial capital expenditure, i.e. $1,702,713, or approximately $300,000 less than our original $2,000,000 capital investment. It is therefore unlikely you would recommend this project. However, would you make the same decision if the discount rate were 6 percent? The revised results indicate an accumulated cost saving of $2,293,984, now signifying a favourable investment. Under these restrained conditions, the final decision would probably reflect your confidence (or lack of it) in either discount rate.
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As a further illustration, assume you are tasked to investigate complaints concerning noisy, expensive to operate and unreliable air-conditioning. Your investigations indicate that the equipment is beyond economic repair and needs replacing. You have selected three potential alternatives, i.e., (i) a variable-air-volume (VAV) system; (ii) a dual conduit system; and (iii) a dual duct VAV system, table 1. Each system has technical advantages.
Each also has LCC implications. If we assume a 25 year time period and a discount rate of 3.5 percent, the net present value (NPV) for each system is equivalent to summing the present value for the initial and replacement equipment costs, plus the present value of all recurring costs (maintenance and energy) and deducting the present value of the energy savings as well as the present value of the salvage, i.e. for the VAV System, $7,164,569; for the Dual Control System, $8,702,920; and for the Dual Duct VAV System, $10,518,706. If we assume energy costs escalate by 2 percent then the NPV figures are $8,406,338, $10,255,130 and $12,433,099 respectively. Hence, irrespective of energy escalation, the VAV System would be the preferred system in terms of its LCC assessment. (Significantly, energy costs account for almost 2/3rds of the total NPV in all three cases, whereas the salvage value represents a mere 0.5 percent NPV.)
What else do we need to know?
Determining the life cycle of a building component, system or structure can often be problematical. Construction materials and building systems are typically robust, rarely catastrophically failing. Hence determining the best time to replace or renovate is difficult. If we ignore maintenance, will this influence the service life? The plain answer is we do not know. Often we make arbitrary assumptions. This is not necessarily a problem with LCC as long as we undertake additional calculations, seeking out cost significance. When determining life-cycle it is also imperative that we acknowledge obsolescence as a key factor. Many building systems may be eminently serviceable, yet technically obsolescent. This is especially true of energy consuming systems. We need look no further than our own personal computer to understand the influence of time on equipment. Financial obsolescence can also heavily influence LCC. Hong Kong can be quite cavalier when it comes to demolishing buildings that potentially have many years of service life yet are replaced by more financially attractive options, e.g. the impending demolition of the Ritz Carlton Hotel in Central after a “life-span” of less than 20 years.
It should also be noted that “the accuracy of LCC diminishes as it projects further into the future, so it is most valuable as a comparative tool when long term assumptions apply to all the options and consequently have the same impact”, Office of Government Commerce, UK. Even at modest discount rates, NPV reduces rapidly, hence making capital investments for long-term performance unattractive (see table bottom right). The corollary is also true, i.e. higher discount rates tend to favour LCC options with low capital cost, a short life span and high recurring costs.
Lastly, LCC calculations can be tedious, so it is best to employ software to undertake the necessary iterative assessment. Excel has many LCC functions “built-in” and other formulae can be quickly embedded in a LCC spreadsheet. However, when risk and uncertainty are also assessed, custom software is preferable.
Facility management and corporate real estate companies wishing to undertake in-house LCC training please contact the author at The Sloane Partnership, jdgilleard@gmail.com.
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Equations used:
1. Compound interest: FV = PV * ((1+i)^n)
2. Single present value: PV = FV / (1+r)^n
3. Present value of an annuity: PVA = FV / [((1+r)^n -1) / (r * (1+r)^n)]
4. Present value of an annuity with escalation: PVAe = FV * { [((1+e) / (1+r)) * ((1+e) / (1+r)^n) -1] / [((1+e) / (1+r)) -1] – 1}
5. Discounted real rate of return: r = ((1+i) / (1+inf)) -1 Where:
PV = time equivalent present value
PVA = time equivalent present value of an annuity
PVAe = time equivalent present value of an annuity with escalation
FV = time equivalent future value
i = rate of return (interest)
inf = inflation rate
e = escalation rate
r = discounted real rate of return
n = time period (years)
