When life gets complicated

I’m sure everyone has lost count of the number of times there have been calls for greater use of life-cycle costing (LCC) or whole-life costing (WLC). But their use in practice seems as rare as ever. Why is this?

Perhaps the search for explanations could begin with the formidable 2008 Standardised Method of Life Cycle Costing Procurement, the guide to British Standard ISO 15686-5. For many readers, it must be as intimidating as the first day in the army for a new recruit. Immediately apparent is the requirement to collect very large amounts of information regarding initial and operating costs, together with the life expectancies of numerous building components and systems. This in itself will lead many managers and designers to question whether to proceed further.

It gets worse. The assembly of detailed data can only happen after design development is well advanced, but the most influential decisions tend to be made early, at a point when details are fuzzy, and non-pecuniary matters, such as social and environmental issues, are being dealt with. As a project goes on, more information becomes available to make a detailed LCC/WLC analysis possible, but by this time the main decisions have been made. Late-stage, detailed analysis is a weak design aid.

But that is not all. Having obtained a mountain of data, one hits the problem of selecting the discount rate for the analysis. In a typical business finance textbook, discount rate selection may fill several chapters. In the Standardised Method ISO book of 87 pages, it gets just half a page, and the advice given is contrary to that learned by second-year business students. Uncertainty is a major factor in determining discount rate, and no analysis is complete without carefully dealing with it. For example, few people will expect the same return from a low-risk mortgage as an equity investment in, say, a new resort development, and this should be reflected in different discount rates – it is inappropriate to use mortgage or deposit rates when assessing building projects.

For many readers, approaching the Standardised Method of Life-Cycle Costing Procurement must be as intimidating as the first day in the army for a new recruit

The importance of getting the discount rate right is illustrated by the following example. Take two ventilation systems. “A” has an initial cost of £500,000 and costs £50,000 per year to operate; system “B” costs £350,000 but has a higher operating cost of £68,000. Which system offers the best whole-life costs depends on the discount rate used. If the discount rate is low, say below 10%, option A is the most attractive. But if the discount rate exceeds 10%, then option B is the best bet. But choosing the right rate is extremely complex. If the difference in the running cost savings between A and B is based on fuel savings, the appropriate discount rate would relate to the volatility of energy costs which is high. On the other hand, if the difference in costs relates to a much less risky factor, then that would have a big impact on the discount rate chosen.

A further issue, completely overlooked in the Standardised Method of LCC/WLC is the role of what are termed “real options”. For example, the option value attached to many short-life components is undervalued by traditional LCC/WLC, because when replacement occurs, some future manager can make a new decision, perhaps selecting from better products that do not now exist. The potential benefit arising from giving managers the ability to make better decisions in the future creates option value today. Many experienced managers and designers have acquired an intuitive feel for option value and thus are uneasy about standard LCC/WLC. They may therefore (correctly) go for a cheaper, short-life component, in the face of an LCC/WLC analysis that suggests otherwise.

The attempt to introduce the Standardised Method is probably doomed – thankfully. New approaches to LCC/WLC are needed. Our rather backward industry should look to the management disciplines for innovative approaches that can be adapted to our very specific needs.