RELI ABI LI TY ENGI NEERI NG UNI T

ASST4403
Lec t ur e 34 LI FE CYCLE COSTI NG
1
Learning outcomes
Understand the concept of time value of money and
l l t NPV f i t t d i i calculate NPV for investment decisions
Articulate different costs involved in an asset
Basic LCC concepts
2
Terminology Terminology
Acquisition costthe initial cost to gain possession of the
completed product. Includes any research,
development, testing and evaluation costs, as well as
the investment and installation cost the investment and installation cost.
Base datethe date to which real costs refer, and to
which discounted costs refer.
Cost drivercost element which has a major effect on the j
LCC.
Cost elementan aspect of the product to be modelled A Cost elementan aspect of the product to be modelled. A
cost element is generated from a collection of variables,
rates, factors and constants expressed in money terms. p y
The number and choice of cost elements depends on
the purpose of the LCC analysis.
3
Terminology Terminology
Dependabilitythe ability of the product to perform over
its life as the user expects its life as the user expects.
Discounted costthe resulting value when real cost is
discounted by the real discount rate, or when nominal
cost is discounted by the nominal discount rate.
Disposal costthe cost of removing a product after its
usefulness has ended, including costs to decommission,
di tl k i t ll f t t d dismantle, make environmentally safe, transport and
dump. If the product or its elements are sold and the
proceeds from the sale exceed the other costs of proceeds from the sale exceed the other costs of
disposal, the product will have a disposal value that
reduces the life cycle cost. y
4
Terminology gy
Life cycle cost (LCC)the sum of Acquisition cost and
Ownership cost of a product over its life cycle Ownership cost of a product over its life cycle.
Life cyclethe time interval between a products recognition
of need or opportunity and its disposal.
Life cycle costingthe process of assessing the cost of a y g p g
product over its life cycle or portion thereof.
Nominal costthe expected price that will be paid when a Nominal cost the expected price that will be paid when a
cost is due to be paid, including estimated changes in price
due to forecast changes in efficiency, inflation/deflation,
technology and the like.
Nominal discount ratethe rate to use when converting Nominal discount rate the rate to use when converting
nominal costs to discounted costs. The rate includes a
component for general price inflation.
5
Terminology
Ownership costsummation of all operating expenses,
maintenance, support and disposal costs borne by the owner
or user of a complete product during its life cycle or user of a complete product during its life cycle.
Productthe result of activities or processes that fulfill a
required need A product can be tangible or intangible or a required need. A product can be tangible or intangible, or a
combination thereof. A product may include services (for
example banking), hardware (for example parts), software
(for example applications and/or tools), processed materials
(for example raw materials) or a combination thereof.
Real costthe cost expressed in values of the base date,
including estimated changes in price due to forecast
changes in efficiency and technology excluding general changes in efficiency and technology, excluding general
price inflation or deflation.
Real discount rate the rate to use when converting real costs Real discount ratethe rate to use when converting real costs
to discounted costs. The rate does not include a component
for general price inflation.
6
What is life-cycle for an asset?
The time interval between a products recognition
f d t it d it di l of need or opportunity and its disposal
Time interval that commences with the
identification of the need for an asset and identification of the need for an asset and
terminates with the decommissioning of the asset or
any liabilities hereafter
7
What about different perspectives
Life cycle from a marketing perspective
Introduction Growth Maturity Decline
Life cycle from a production perspective
Product conception Design Product development Product conception Design Product development
Production Logistics
Life cycle from a consumer perspective
Purchase Operating Support Maintenance p g pp
Disposal -
8
Time value of money
Net Present
Value
Future Cash Flows
+
+
+ +
+
+
=
Net Present Value (NPV) is a metric that is suitable for valuing
time
Net Present Value (NPV) is a metric that is suitable for valuing
projects because it can deal with the
Timing aspect of cash flows
Risk aspect of cash flows
by discounting or penalizing future cash flows.
Recognises that a $ today is worth more than a $ tomorrow
9
Time Value of Money Time Value of Money
Future Value = Present Value (1 + r)
n
F = P (1 + r)
n
Rearranging
P V l F V l Present Value = Future Value
(1+r)
n
P = F/ (1+r)
n
The process of finding present values is called
DISCOUNTING
Discount rate (r) reflects both: the time value of money Discount rate (r) reflects both: the time value of money
AND a compensation for risk
10
Ho do e calc late NPV? How do we calculate NPV?
P d Procedure:
write down uninflated cash flows for the project.
convert future cash flows to a present value (select
appropriate date) using the discount rate (r). pp p ) g ( )
SUM the present values of the cash flows to determine
the net present value (NPV) of the investment or the net present value (NPV) of the investment or
project.
C C C

n
n
r
C
r
C
r
C
C NPV

1
..
) 1 ( ) 1 (
2
2
1
1
0
11
Quiz Question
$5000 $3000 $100 $100 $100 $100
0 1 2 3
Calculate the NPV for the cash flows shown here using a
discount rate of 8% discount rate of 8%.
Whats your answer?
12
Quiz questions Q q
1. What is the present value of $1,050.00 to be received in
1 years time with an interest rate of 5%? ($??) 1 year s time, with an interest rate of 5%? ($??)
2. What is the present value of $1,102.50 to be received in
$ 2 years time, with an interest rate of 5%? ($??)
3. How much will be accumulated by an investment of y
$52,500 at 8% compounded annually over 5 years?
($77,140)
4. What is the present value of a year end series of
receipts of $600 over 5 years at 8% compounded
annually? ($2,396)
13
Real and nominal discount
t rates
r = Real discount rate
i = inflation
N i l di t t p = Nominal discount rate
Conversion between real and nominal
r = (p i)/ (1 + i)
p = r + i(1+r) p = r + i(1+r)
If the real discount rate is 8% and inflation 2%, the
nominal discount rate is 10 16% nominal discount rate is 10.16%
If the nominal discount rate is 8% and inflation 4%,
the real disco nt rate is 3 85% the real discount rate is 3.85%
14
Jelly Bean example Jelly Bean example
I can buy 100 jelly beans for $1 today.
Consider an inflation rate is 5%. This means that in
one years time, 100 jelly beans will cost $1.05.
Suppose that the bank interest rate is 13.4%. Then
if I invest $1 now, I will have $1.134 in one years
ti H i ti I ill b bl t b time. Hence, in one years time I will be able to buy:
100 x (1.134/1.05) = 108 jelly beans
Th l t f i t t th 8% The real rate of interest over the year was 8%,
since I can buy 8% more jelly beans at the end than
at the beginning g g
The real rate of interest is the number of extra jelly
beans that I can buy in one years time if I invest the y y
$1 and collect the interest.
15
Rate of return Rate of return
Rate of return r* is a widely accepted index of y p
profitability.
ROR is defined as the interest rate that causes the
equivalent receipts of money flow to be equal
equivalent disbursements of that money flow, in other
words the balance is zero words the balance is zero.
0 1 ) (
0
* *

n
n
n
r C r NPV
Mathematically the rate of return for an investment
proposal is the rate r* that satisfies the equation shown
below
0
below.
There is a useful IRR function in Excel for calculating
this this.
16
Payback
Investments can be evaluated in terms of how long it will
take the system to pay for itself from benefits revenue take the system to pay for itself from benefits, revenue,
savings.
S stems that pa for themsel es q ickl are often Systems that pay for themselves quickly are often
desirable because there is less uncertainty with
estimates of short duration estimates of short duration.
Payback period is the amount of time required for the
difference in the present value of savings to equal the difference in the present value of savings to equal the
present value of the costs.
f Payback period may be calculated by interpolating from
graphs or tables. There is no Excel function for this.
17
Graphical Representation of Replacement Decision over
Different Intervals
How can we compare the value of two investments one
Replace
Purchase
How can we compare the value of two investments, one
with a life of 3 years, the other with 8 years?
0 1 2 3
Replace
Purchase
0 1 2 3 0 1 2 3
4 5 6 7 8
18
Equivalent Annual Cost (EAC) Equivalent Annual Cost (EAC)
To evaluate asset investments with different service lives
use an Equivalent Annual Cost (EAC) calculation
This determines the cost per year of owning and This determines the cost per year of owning and
operating an asset over its entire lifespan
EAC is calculated by multiplying the NPV by a capital
recovery factor
EAC = NPV x CRF
CRF [ *(1 ) ] / [(1 ) 1] CRF = [r*(1+r)] / [(1+r) 1]
19
Clarification about EAC terminology
In some literature (and in this course) EAC refers to
th NPV * CRF h i Bl h d thi f l i the NPV * CRF however in Blanchard this formula is
called the Annual Equivalent Evaluation AE(i).
When Blanchard (Section 8 3 6) uses the term When Blanchard (Section 8.3.6) uses the term
Annual Equivalent Cost he is referring only to the
cost of the asset not the NPV.
Please ensure when you use the term EAC you are
clear about what it means.
20
What is life-cycle costing?
A process to determine the sum of all expenses
i t d ith d t i l di i iti associated with a product, including acquisition,
installation, operation, maintenance, refurbishment,
discarding and disposal costs (AS/NZS discarding and disposal costs. (AS/NZS
4536:1999)
LCC involves the identification of all costs
associated with a system as applied to the defined
life cycle. It must take risks and uncertainty into
account in order to be really useful for decision account in order to be really useful for decision-
makers
21
The objectives of LCC
(a) Calculate a dollar value representing the LCC of a
d t i t t d i i ki product as an input to a decision making or
evaluation process together with other inputs. The
cost is based on a defined need associated with the cost is based on a defined need associated with the
product.
(b) S pport management considerations affecting (b) Support management considerations affecting
decisions during any life-cycle phase.
(c) Identify the attributes of the product which
significantly influence the LCC (cost drivers) of the
product so that they can be properly managed product so that they can be properly managed.
22
Use of LCC Use of LCC
23
Why is it important?
Assists companies to eliminate costs before they are y
incurred and, to manage some crucial business risks
related to costs, cash flow and profitability.
By
Making total system cost of an asset/ product visible g y p
Highlighting the cost contribution from all phases when
making decisions on equipment selection and operation making decisions on equipment selection and operation
Understanding cause-effect relationships
Avoiding decisions made solely on consideration of
purchase price.
24
Di d li d Discounted costs are applied to
evaluation and comparison of alternative design p g
approaches, for products with long lives;
assessing the impact of new technology;
evaluation and comparison of alternative strategies for
product use, operation, testing, inspection, maintenance,
d th lik and the like;
evaluation and comparison of different approaches for
replacement rehabilitation or retirement of ageing replacement, rehabilitation or retirement of ageing
facilities;
benefit-cost analysis and trade-off studies to determine benefit-cost analysis and trade-off studies to determine
the optimum performance, reliability, maintainability and
other requirements;
25
Di d li d Discounted costs are applied to
selecting amongst competing tenders for products with selecting amongst competing tenders for products with
long lives;
assessment of economic viability of products; assessment of economic viability of products;
selecting the optimal procurement policy; and
bli b i f i f d t enabling a common basis of comparison for products
with significantly different cost profiles.
26
When/ where is it appropriate
EVALUATING
ALTERNATIVE
SUPPLIER
EVALUATING
ALTERNATIVE
DESIGN
EVALUATING
ALTERNATIVE
PRODUCTION
PROPOSALS CONSIDERATIONS PROFILES
LIFE-CYCLE COST
APPLICATIONS
JUSTIFYING
EQUIPMENT/
COMPONENT
REPLACEMENT
COMPARING
LOGISTICS &
MAINTENANCE
SUPPORT POLICIES
DECISIONS
SUPPORT POLICIES
IDENTIFICATION OF
HIGH COST
CONTRIBUTORS
(AREAS OF RISK)
LONG-RANGE
PLANNING,
BUDGETING, AND
ALLOCATION OF
RESOURCES
PROJECT
MANAGEMENT &
CONTROL
RESOURCES
Reference: Blanchard, B.S. & Fabrycky, W.J. (2006) Systems Engineering and Analysis,
Prentice Hall. Figure D.10
27
Ti i Timing
50-70% of the life 5 7
cycle cost for a
given system can be
l k d d i h locked during the
early stages of the
life cycle life cycle.
A large % of costs
i t d ith are associated with
the operation and
maintenance phase maintenance phase
but the opportunity
to influence those
costs is at the start
of the life cycle.
28
f Opportunities for
cost savings in the
life cycle life cycle
29
Cost element concept 30
Usual costs
The usual costs and expenses include
Capital costs
Buildings and Equipment Buildings and Equipment
Expenses
Labour Supplies Raw materials Utilities Disposal Labour, Supplies, Raw materials, Utilities, Disposal
Revenues
P i d t k t bl b d t Primary product, marketable by-product
31
Hidden costs
These are usually associated with regulation.
They are often lumped together into overhead costs
allocated to products/ assets using direct labour or
machine hours.
Examples include p
Capital costs
M it i i t d d t ti Monitoring equipment, preparedness and protective
equipment, additional technology
Expenses Expenses
Reporting, notification, monitoring/ testing, record
keeping planning/ studies training inspections keeping, planning/ studies, training, inspections,
labelling, postclosure care, medical surveillance,
insurance.
32
The I c eber g The I c eber g
Poor Management
The Life Cycle Cost Iceberg
Source:
B.S. Blanchard and W.J. Fabrycky, Systems
Engineering and Analysis, Prentice Hall, 2006.
33
Liability costs
Legal staff and/ or consultants
Penalties and fines
Future liabilities from customer injury Future liabilities from customer injury
Future liabilities from hazardous waste sites
34
S f d t
Engineering
Sources of data
Engineering
design data
Management
CMMS data
Reliability
data
g
planning data
LIFE CYCLE
COST DATA
Logistic
Accounting
data
support data
Customer/
Production
data
Construction
data
Market data
35
Example Example
For a mobile equipment asset, characteristics that effect q p ,
how future costs are predicted include:
The current hours of operation recorded against the The current hours of operation recorded against the
machine. This is important as it effects when the next
component change-outs are scheduled. p g
The expected availability and utilisation of the machine.
This again will affect the timing of when change-outs will This again will affect the timing of when change outs will
occur as it dictates how many hours the machine will be
expected to run each month.
The cash rate for labour such that those costs are
factored into the overall costs of maintenance jobs in the factored into the overall costs of maintenance jobs in the
future.
(from M.Cross, UWA Honours 2007)
36
Comparison of Option 1 and 2
14000
16000
18000
80%
90%
100%
30000
35000
40000
80%
90%
100%
4000
6000
8000
10000
12000
14000
C
o
s
t
/
y
r
20%
30%
40%
50%
60%
70%
80%
%

o
f

t
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10000
15000
20000
25000
30000
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o
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/
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20%
30%
40%
50%
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Total Sustaining
cost=$54,827/yr
Total Sustaining
cost=$21,493/yr cost $ 54,827/yr cost $ 21,493/yr
37
Criteria for decision making
Common factors used to trade-off for LCC are
operational availability,
intrinsic availability intrinsic availability,
spares cost,
manpower cost,
b bilit f i i probability of mission success.
38