July 24, 2007

Life Cycle Cost (LCC) Analysis

Life-cycle cost analysis (LCCA) is a method for assessing the total cost of facility ownership. It takes into account all costs of acquiring, owning, and disposing of a project. LCCA is especially useful when project alternatives that fulfill the same performance requirements, but differ with respect to initial costs and operating costs, have to be compared in order to select the one that maximizes net savings.

For example, LCCA will help determine whether the incorporation of a good HVAC or glazing system, which may increase initial cost but result in dramatically reduced operating and maintenance costs, is cost-effective or not.

LCCA is not useful for budget allocation.

Lowest life-cycle cost (LCC) is the most straightforward and easy-to-interpret measure of economic evaluation. Some other commonly used measures are Net Savings (or Net Benefits), Savings-to-Investment Ratio (or Savings Benefit-to-Cost Ratio), Internal Rate of Return, and Payback Period. They are consistent with the Lowest LCC measure of evaluation if they use the same parameters and length of study period. The approach to making cost-effective choices for projects can be quite similar.

A. Life-Cycle Cost Analysis (LCCA) Method

The purpose of an LCCA is to estimate the overall costs of project alternatives and to select the design that ensures the facility will provide the lowest overall cost of ownership consistent with its quality and function. The LCCA should be performed early in the design process while there is still a chance to refine the design to ensure a reduction in life-cycle costs (LCC).

The first and most challenging task of an LCCA, or any economic evaluation method, is to determine the economic effects of alternative designs of project and to quantify these effects and express them in money terms.

B. Costs

There are numerous costs associated with acquiring, operating, maintaining, and disposing of a project. Related costs usually fall into the following categories:

  • Initial Costs—Purchase, Acquisition, Construction Costs

  • Fuel Costs

  • Operation, Maintenance, and Repair Costs

  • Replacement Costs

  • Residual Values—Resale or Salvage Values or Disposal Costs

  • Finance Charges—Loan Interest Payments

  • Non-Monetary Benefits or Costs

Only those costs within each category that are relevant to the decision and significant in amount are needed to make a valid investment decision. Costs are relevant when they are different for one alternative compared with another; costs are significant when they are large enough to make a credible difference in the LCC of a project alternative. All costs are entered as base-year amounts in today's money; the LCCA method escalates all amounts to their future year of occurrence and discounts them back to the base date to convert them to present values.

Initial costs
Initial costs may include capital investment costs for land acquisition, construction, or renovation and for the equipment needed to operate a facility.

Land acquisition costs need to be included in the initial cost estimate if they differ among design alternatives. This would be the case, for example, when comparing the cost of renovating an existing facility with new construction on purchased land.

Construction costs

Detailed estimates of construction costs are not necessary for preliminary economic analyses of alternative designs or systems. Such estimates are usually not available until the design is quite advanced and the opportunity for cost-reducing design changes has been missed. LCCA can be repeated throughout the design process if more detailed cost information becomes available. Initially, construction costs are estimated by reference to historical data from similar facilities.

Energy and Water Costs

Operational expenses for energy, water, and other utilities are based on consumption, current rates, and price projections. Energy costs are often difficult to predict accurately in the design phase of a project. Assumptions must be made about use profiles, Efficiency variations, and schedules, all of which impact energy consumption. At the initial design stage, data on the amount of energy consumption can come from engineering analysis.

Energy prices

Quotes of current energy prices from local suppliers should take into account the rate type, the rate structure, summer and winter differentials, block rates, and demand charges to obtain an estimate as close as possible to the actual energy cost.

Energy price projections

Energy prices are assumed to increase or decrease at a rate different from general price inflation. This differential energy price escalation needs to be taken into account when estimating future energy costs. Energy price projections can be obtained either from the supplier or from energy price escalation rates published annually on April 1 by DOE in Discount Factors for Life-Cycle Cost Analysis, Annual Supplement to NIST Handbook 135.

Water Costs

Water costs should be handled much like energy costs. There are usually two types of water costs: water usage costs and water disposal costs.

Operation, Maintenance, and Repair Costs

Non-fuel operating costs, and maintenance and repair (OM&R) costs are often more difficult to estimate than other expenditures. Operating schedules and standards of maintenance vary from project to project and equipment to equipment; there is great variation in these costs even for projects / equipments of the same type and age. It is therefore especially important to use engineering judgment when estimating these costs.

Replacement Costs

The number and timing of capital replacements of equipments depend on the estimated life of the system and the length of the study period. Use the same sources that provide cost estimates for initial investments to obtain estimates of replacement costs and expected useful lives. A good starting point for estimating future replacement costs is to use their cost as of the base date. The LCCA method will escalate base-year amounts to their future time of occurrence.

Residual Values

The residual value of a system (or component) is its remaining value at the end of the study period, or at the time it is replaced during the study period. Residual values can be based on value in place, resale value, salvage value, or scrap value, net of any selling, conversion, or disposal costs. As a rule of thumb, the residual value of a system with remaining useful life in place can be calculated by linearly prorating its initial costs. For example, for a system with an expected useful life of 15 years, which was installed 5 years before the end of the study period, the residual value would be approximately 2/3 (=(15-10)/15) of its initial cost.

Other Costs

Finance charges and taxes: For small projects, finance charges are usually not relevant. Finance charges and other payments apply, however, if a project is financed through any outside agency. The finance charges are usually included in the contract payments negotiated with the Energy Service Company (ESCO) or the utility.

Non-monetary benefits or costs

Non-monetary benefits or costs are project-related effects for which there is no objective way of assigning a dollar value. Examples of non-monetary effects may be the benefit derived from a particularly quiet HVAC system or from an expected, but hard-to-quantify productivity gain due to improved lighting. By their nature, these effects are external to the LCCA, but if they are significant they should be considered in the final investment decision and included in the project documentation.

To formalize the inclusion of non-monetary costs or benefits in your decision making, you can use the analytical hierarchy process (AHP), which is one of a set of multi-attribute decision analysis (MADA) methods that consider non-monetary attributes (qualitative and quantitative) in addition to common economic evaluation measures when evaluating project alternatives.

C. Life-Cycle Cost Calculation

After identifying all costs by year and amount and discounting them to present value, they are added to arrive at total life-cycle costs for each alternative:

LCC = I + Repl — Res + E + W + OM&R + O

LCC = Total LCC in present-value (PV) dollars of a given alternative

I = PV investment costs

Repl = PV capital replacement costs

Res = PV residual value (resale value, salvage value) less disposal costs

E = PV of energy costs

W = PV of water costs

OM&R = PV of non-fuel operating, maintenance and repair costs.

O = PV of other costs (e.g., contract costs)

D. Supplementary Measures

Supplementary measures of economic evaluation are

  • Net Savings (NS),

  • Savings-to-Investment Ratio (SIR),

  • Adjusted Internal Rate of Return (AIRR),

  • Simple Payback (SPB) or

  • Discounted Payback (DPB).

All supplementary measures are relative measures, i.e., they are computed for an alternative relative to a base case.

NS = Net Savings: operational savings less difference in capital investment costs

SIR = Savings-to-Investment Ratio: ratio of operational savings to difference in capital investment costs

AIRR = Adjusted Internal Rate of Return: annual yield from an alternative over the study period, taking into account reinvestment of interim returns at the discount rate.

SPB = Simple Payback: time required for the cumulative savings from an alternative to recover its initial investment cost and other accrued costs, without taking into account the time value of money.

DPB = Discounted Payback: time required for the cumulative savings from an alternative to recover its initial investment cost and other accrued costs, taking into account the time value of money

E. Evaluation Criteria

  • Lowest LCC (for determining cost-effectiveness)

  • NS > 0 (for determining cost-effectiveness)

  • SIR > 1 (for ranking projects)

  • AIRR > discount rate (for ranking projects)

  • SPB, DPB <>

F. Uncertainty Assessment in Life-Cycle Cost Analysis
Decisions about investments typically involve a great deal of uncertainty about their costs and potential savings. Performing an LCCA greatly increases the likelihood of choosing a project that saves money in the long run. Yet, there may still be some uncertainty associated with the LCC results. LCCAs are usually performed early in the design process when only estimates of costs and savings are available, rather than certain dollar amounts. Uncertainty in input values means that actual outcomes may differ from estimated outcomes.

There are techniques for estimating the cost of choosing the "wrong" project alternative. Deterministic techniques, such as sensitivity analysis or breakeven analysis, are easily done without requiring additional resources or information. They produce a single-point estimate of how uncertain input data affect the analysis outcome. Probabilistic techniques, on the other hand, quantify risk exposure by deriving probabilities of achieving different values of economic worth from probability distributions for input values that are uncertain. However, they have greater informational and technical requirements than do deterministic techniques. Whether one or the other technique is chosen depends on factors such as the size of the project, its importance, and the resources available. Since sensitivity analysis and break-even analysis are two approaches that are simple to perform, they should be part of every LCCA.

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