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In this Aug 2005 issue of On Target :
Life Cycle Costing: The Lesson of Ansett Airlines
What's On
Bookshelf
Life Cycle Costing : The lesson of Ansett Airlines
Why did Ansett Airlines fail in 2001, with huge losses and a shortage of cash, when it had made a good profit in the previous year? Was bad management at the time of failure or bad decisions taken in the past when the company was seemingly profitable? The reason was the latter, as Ansett had over the years purchased a number of different brands and varieties of aircraft (Boeing, McDonald Douglas, Lockheed, Airbus, etc.); each brand having the lowest initial acquisition price at time of purchase. However, this resulted in the airline having the greatest variety in their stable of aircraft, thus requiring different spare parts, hangers, and trained technicians etc., i.e. unsustainable running (operating) costs in the long run.
In the past, comparisons of asset alternatives, whether at the concept or detailed design level, have been based mainly on initial capital costs. However, due to the lessons learnt from companies like Ansett, there has been growing pressure to achieve better outcomes from assets, ongoing operating and maintenance costs must be considered as they consume most resources over the asset’s service life.
Life Cycle Costing is a process to determine the sum of all the costs associated with an asset or part thereof, including acquisition, installation, operation, maintenance, refurbishment and disposal costs. It is therefore pivotal to the asset management process.
Life Cycle Costing incorporates both Life Cost Planning which occurs during development or manufacture and implementation of that plan by Life Cost Analysis as the asset is used or occupied.
Doing a life-cycle cost analysis (LCC) gives the total cost of your asset- including all expenses incurred over the life of the asset. There are two reasons to do an LCC analysis: 1) to compare different asset options and 2) to determine the most cost-effective asset designs. A meaningful LCC comparison can only be made if each asset alternative can perform the same work with the same level of reliability.
The term "Life-Cycle Costing" is quite broad and encompasses all those techniques that take into account both initial costs and future costs and benefits (savings) of an investment over some period of time. They differ, however, in their applications which depend on various purposes of investment projects. For example, in the case of real estate assets, for new buildings the LCC technique is used to evaluate (or rank) the options concerning design, sites, and materials on the basis of total life-cycle costs. Its application to existing buildings involves: 1. comparison of total life-cycle costs and savings of rehabilitating the existing building vis-à-vis redeveloping it, i.e., tearing it down and rebuilding it; 2. determining how much of any given retrofitting measure or a combination of various retrofitting measures should be used in order to achieve maximum savings, given certain constraints of budget, level of amenity, etc.; and 3. determining which method of retrofitting or rehabilitating a building be used to achieve maximum savings from a given level of investment costs.
The life-cycle cost of a project or asset can be calculated using the formula :
LCC = C + Mpv + E pv + R pv - S pv
where the pv subscript indicates the present value of each factor.
The capital cost (C) of a project includes the initial capital expense for equipment, the asset design, engineering, and installation. This cost is always considered as a single payment occurring in the initial year of the project, regardless of how the project is financed.
Maintenance (M) is the sum of all yearly scheduled operation and maintenance (O&M) costs. Fuel or equipment replacement costs are not included. O&M costs include such items as an operator's salary, inspections, insurance, property tax, and all scheduled maintenance.
The energy cost (E) of an asset is the sum of the yearly fuel cost. Energy cost is calculated separately from operation and maintenance costs, so that differential fuel inflation rates may be used.
Replacement cost (R) is the sum of all repair and equipment replacement cost anticipated over the life of the asset. The replacement of a battery is a good example of such a cost that may occur once or twice during the life of a motor vehicle asset. Normally, these costs occur in specific years and the entire cost is included in those years.
The salvage value (S) of an asset is its net worth in the final year of the life-cycle period. It is common practice to assign a salvage value of 20 percent of original cost for mechanical equipment that can be moved. This rate can be modified depending on other factors such as obsolescence and condition of equipment.
As life-cycle costs are spread over many years they must be converted to a common value (present or annual value) in order to make them comparable over a period of time. Assumptions must therefore be specified regarding the cost of capital rate, economic life of building components, inflation rate, future energy, and non-energy cost escalation rates.
Before finally selecting an investment project, it is sometimes desirable to test its economic feasibility based on alternative values of key parameters uncertain in the future, e.g., life of the building, energy price escalation rate, and discount rate. It is also important to know the value or range of values of parameters that affect the LCC analysis. This can be done by recomputing the LCC measure for minimum and maximum values of the parameters in question, using a technique called "sensitivity analysis." This informs the decision-maker of the consequences associated with uncertainties in the data.
In brief, an LCC analysis requires the following steps :
Specify the objectives and constraints of the analysis.
Identify options to achieve the objectives.
Specify various assumptions regarding discount rate, inflation rate, economic life, etc.
Identify and estimate relevant costs.
Convert all costs into constant dollars and to a common base.
Compare the total life-cycle costs for each option and select the one with the minimum total costs.
Analyse the results for sensitivity to the initial assumptions.
Summary
LCC is a valuable method of tracing the cost consequences of various alternative investment projects with long life spans. It is now used in both the public and private sectors as a tool to select the best investment option for new asset acquisitions and to determine the feasibility of alternative assets. However, because the application of LCC requires prior specification of several parameters and a considerable amount of prediction about them, the limitations of the method must be clearly understood. Efforts should be made to improve its value by developing a data bank on the various components of the total life-cycle costs.
What's On
August 4-15, 2005
Strategic Management Accounting, 7-Day Seminar in Sri Lanka
Conducted by the Institute of Chartered Accountants of Sri Lanka and ICMA
August 6, 2005
Exam: CMA-Batch 4: Advanced Management Accounting & Advanced Strategic Management Accounting, Manila, Philippines.
August 7, 10, 21, 28 and September 4, 2005
Strategic Cost Management, Monash University
[Approved as a CMA subject by ICMA as equivalent to Advanced Management Accounting]
August 13 - September 24, 2005
CAT Batch 3 in the Philippines by cmaphilippines and ICMA
CMA Batch 6 - August 20 - November 5, 2005
Advanced Management Accounting & Advanced Strategic Management Accounting 12-day Seminars (6th Batch) in the Philippines by cmaphilippines and ICMA
September 13 to 17
MAA Course in Financial and Managerial Accounting, by the Australian Institute for Business and Sciences, Tripoli, Lebanon.
September 15- First intake of the CAT program by the Australian Institute of Finance and Management and ICMA
September 21- ICMA AGM: Held at CMA House.
September 22 to October 1, 2005
Advanced Management Accounting & Advanced Strategic Management Accounting
7-Day Seminar in Beirut, Lebanon
Conducted by cmalebanon and ICMA
Book Shelf
Readers may have noticed a few articles on German Cost Accounting in Strategic Finance over the past few months. For example, Gunther Friedl and others in the June 2005 issue wrote about Grenzplankostenrechnung (or GPK for short) and Kip Krumwiede in the April 2005 issue reported on an IMA sponsored study involving German, Austrian and Swiss companies, academics and consultants under the heading of “the rewards and realities of German cost accounting”.
German cost and management accounting has been of interest for some time. In 1992, for example, Nicholas Strange wrote about German management accounting in CIMA’s Management Accounting (October issue). The topic has even made the pages of Accounting, Organisations and Society with an ethnographic study of German and British brewers by Thomas Ahrens (“Talking accounting: An ethnography of management knowledge in British and German brewers”, October, 1997 issue).
More recently, Anton van der Merwe in the Winter, 2004 issue of Management Accounting Quarterly has written an overview of the introductory chapter to the latest edition of the pre-eminent German cost accounting textbook, including standard costing and GPK, and looks at some of the developments that have had an impact on US management accounting and other developments that should be considered as German cost accounting moves forward.
Recent articles in the academic literature include an article by Peter Kajuter and Harri Kulmala in Management Accounting Research (June 2005 issue) on “Open-book accounting in networks: Potential achievements and reasons for failures”. This article reports on contingency framework based case studies of a German car manufacturer (a single case to describe open-book accounting in detail) and three Finnish manufacturing networks (a cross-case analysis of the reasons why open-book accounting fails).
For those interested in management accounting in other parts of the world, Thomas Lin and others have written on “Target Costing and Incentive Compensation” (Cost Management, March/April, 2005), reporting on the success of advanced cost management and incentive techniques used by Handan Iron and Steel Co. in China.
Bill Richardson
Please feel free to share anything that you have found interesting. You can send your ideas to: Bill Richardson, Dept of Accounting & Finance, Monash University, PO Box 197, Caulfield East VIC 3145.
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