Life Cycle Costing

What is Life Cycle Costing?

Life Cycle Costing is a method that aggregates all costs that an organisation or individual will incur over the life span of the asset, project, investment etc. It includes both the initial investment (non-recurring expense) along with any further investment such as operating cost, maintenance and repair, upgrades (recurring expense).

Life cycle costing is also known as whole life costing. Its primary purpose is to help management decide whether or not to go ahead with a project or acquire an asset. Management usually analyses the cost of ownership as well as operating cost, and then eventually chooses the asset with the minimum overall cost.

Process

We can break down the life cycle costing process into the following cost heads – initial investment, recurring cost, disposal cost and residual value.

Life Cycle Costing

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Source: Life Cycle Costing (wallstreetmojo.com)

Formula

We can derive the value of whole life costing by identifying all the cost heads as well as their corresponding period of occurrence, then discounting them to present value and then adding them up while deducting the present value of the residual value. Mathematically, it can be represented as,

Life Cycle Costing Formula = Initial Cost + PV of All Recurring Costs – PV of Residual Value

Example of Life Cycle Costing

Let us take the example of John, who wants to purchase a new car worth $12,000. As per estimates, the annual expense towards maintenance & repair will be $1,000, and gas consumption per year will be another $3,500. Calculate the life cycle costing of the car if John is planning to sell the car after 5 years at a residual value of $3,000. Please consider the applicable interest rate to be 8%.

Given,

  • Initial cost = $12,000
  • Recurring cost = Maintenance & repair + Gas consumption
  • = $1,000 + $3,500
  • = $4,500
  • Residual value = $3,000
  • No. of years = 5
  • Interest rate = 8%
Life Cycle costing Example 1

Now, life cycle costing of the car can be calculated by using the above formula,

Life Cycle costing Example 1-1
  • = $12,000 + $4,500 * [1 – (1 + 8%)-5] / 8% – $3,000 / (1 + 8%)5
  • = $27,925

Applications of Life Cycle Costing

Benefits

  • It provides a precise estimate of the expected cost to be incurred over the life span of the asset.
  • It makes sure that the best decision is made based on an accurate and realistic estimate of costs.
  • It ensures that the management takes early actions to lower both recurring and non-recurring costs.

Effects

The life cycle costing estimates help in the decision-making process where the mutually exclusive option is available. Also, the management can plan on how to reduce the overall cost of the item through the extension of useful life, efficient utilisation or other similar cost rationalisation measures.

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