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.
We can break down the life cycle costing process into the following cost heads – initial investment, recurring cost, disposal cost and residual valueResidual ValueResidual value is the estimated scrap value of an asset at the end of its lease or useful life, also known as the salvage value. It represents the amount of value the owner will obtain or expect to get eventually when the asset is disposed..
- Initial Cost: It is either the purchase price of an item or the initial cost of the set-up in case of a project. In most cases, it also includes the cost of installation.
- Recurring Cost: It represents all those costs that take place after the purchase, which primarily include operating expenseOperating ExpenseOperating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit. and maintenance expense.
- Operating Cost: These costs are associated with the usage of the asset.
- Maintenance Expense: These costs are associated with repair and replacement expenses.
- Disposal Cost: These costs are incurredCosts Are IncurredIncurred Cost refers to an expense that a Company needs to pay in exchange for the usage of a service, product, or asset. This might include direct, indirect, production, operating, & distribution charges incurred for business operations. at the time of disposal of the asset.
- Residual Value: It represents the value of the asset at the end of its useful life. Higher the residual value, lower will be the whole life cost of the asset.
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%.
- 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%
Now, life cycle costing of the car can be calculated by using the above formula,
- = $12,000 + $4,500 * [1 – (1 + 8%)-5] / 8% – $3,000 / (1 + 8%)5
- = $27,925
Applications of Life Cycle Costing
- In capital budgetingCapital BudgetingCapital budgeting is the planning process for the long-term investment that determines whether the projects are fruitful for the business and will provide the required returns in the future years or not. It is essential because capital expenditure requires a considerable amount of funds., the life cycle costing is a critical component of the decision-making process (purchase of asset) as it is used in the estimation of the net cash flows and the expected return on investment (ROI).
- In case of procurement, the department uses it to determine which is the least expensive item and accordingly place the orders.
- In engineering and production fields, this concept is used in the development and manufacturing of goods that incur the least cost to the customer in terms of installation, operating, maintenance, disposal etc.
- In the case of customer service, whole life costing is used with the focus to minimise the amount of replacement, warranty and field service.
- 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.
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.
This article has been a guide to Life Cycle Costing and its definition. Here we discuss its calculation along with formula, example, applications & benefits. You may learn more about finance from the following articles –