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Life-Cycle Costing as a method for comparisons
June 27, 2018
The most reliable method to make cost comparisons of alternative scenarios is to estimate all costs over the whole life-cycle and then discount the cash flows. The Net Present Value (NPV) received can be compared to other alternatives NPV's. 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%. 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):
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 least negative NPV.
- Life Cycle Costing (LCC) or Life-Cycle Cost Analysis (LCCA)
It includes purchase price, installation cost, operating costs, maintenance and upgrade costs, and remaining value or cost at the end of ownership or its useful life. It’s a financial assessment.
- Life Cycle Cost Comparisons
More information: Jens Westerbladh, DataPartner