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Life Cycle Costing

Updated on January 3, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What is Life Cycle Costing?

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

Life Cycle Costing

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Source: Life Cycle Costing (wallstreetmojo.com)

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Formula

We can derive the value of whole life costing by identifying all the cost heads and their corresponding period of occurrence, then discounting them to the 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. Calculate the car’s life cycle cost if John plans to sell the car after five years at a residual value of $3,000. As per estimates, the annual expense for maintenance & repair will be $1,000, and gas consumption per year will be another $3,500. 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 asset’s life span.
  • 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 recurring and non-recurring costs.

Effects

The life cycle costing estimates help decision-making where a mutually exclusive option is available. Also, the management can plan to reduce the item’s overall cost through the extension of useful life, efficient utilization, or other similar cost rationalization measures.

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