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Life-Cycle Costing as a method for comparisons

June 27, 2018

The most reliable method to make cost comparisons of competing solutions is to estimate all costs over the whole life-cycle and then calculating NPV, e.g. using Invest for Excel^®. The Net Present Value (NPV) received can be compared to other alternatives NPV's, using the Invest for Excel^® comparison table. In a cost comparison, the NPV is negative. The best alternative is the scenario with least negative NPV. Payback can't be used as an indicator. IRR and MIRR can sometimes be used, but not always. NPV and NPV as a monthly annuity serve best in cost comparisons.

Let´s illustrate with an example. Assume that a public organization needs more space for its operations. The organization has 4 different ways to solve it:

• They can rent more space,
• they can build new space,
• they can renovate old facilities or
• they can go for a Public-Private-Partnership (PPP).

The 4 alternatives have totally different cash flows, so the only way to compare them is by using the NPV-method.

The numbers in these cases are fictitious and do not reflect reality. We assume a 2% cost inflation and use a discount rate of 3% (Weighted Average Cost of Capital [WACC]). To get the cash flows, all Capex and Opex need to be modeled, including purchase price, construction- and installation cost, operating costs, maintenance and upgrade costs and remaining value or cost at the end of ownership or its useful life.

See the different cash flows of Rent-, New building-, Renovation- and Public-Private-Partnership alternatives in the picture below (press picture to zoom):

Invest for Excel cash flow statements, by scenario:

Invest for Excel comparison table with all four alternative scenarios:

Picture above. When you compare the Present Value of all CAPEX and OPEX for the alternative scenarios, you get an unbiased objective comparison. The result might be surprising. Remember, the best alternative is the scenario with the least negative NPV.

The four alternative cash flows above differ a lot. The Rent alternative gives a flat cash flow, whereas the New building requires a big investment in the beginning. The Renovation alternative has a smaller investment in the beginning compared to new building, but the maintenance and operational costs are higher than for the new building. In the Public-Private Partnership alternative, we assumed that the private partner builds the new building and operates it for 5 years. The public organization pays an all-in fee for 5 years and then acquires the building at the agreed purchase price.