RELIABILITY ENGINEERING UNITASST4403

Lecture 34 LIFE CYCLE COSTING

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Learning outcomes

• Understand the concept of time value of money and l l t NPV f i t t d i icalculate NPV for investment decisions

• Articulate different costs involved in an asset

• Basic LCC concepts

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TerminologyTerminology

Acquisition cost—the initial cost to gain possession of the completed product. Includes any research, development, testing and evaluation costs, as well as the investment and installation costthe investment and installation cost.

Base date—the date to which real costs refer, and to which discounted costs refer.

Cost driver—cost element which has a major effect on the jLCC.

Cost element—an aspect of the product to be modelled ACost element—an 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 yThe number and choice of cost elements depends on the purpose of the LCC analysis.

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TerminologyTerminology

Dependability—the ability of the product to perform over its life as the user expectsits life as the user expects.

Discounted cost—the resulting value when real cost is discounted by the real discount rate, or when nominal cost is discounted by the nominal discount rate.

Disposal cost—the cost of removing a product after its usefulness has ended, including costs to decommission, di tl k i t ll f t t ddismantle, make environmentally safe, transport and dump. If the product or its elements are sold and the proceeds from the sale exceed the other costs ofproceeds from the sale exceed the other costs of disposal, the product will have a disposal value that reduces the life cycle cost.y

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Terminologygy

Life cycle cost (LCC)—the sum of Acquisition cost and Ownership cost of a product over its life cycleOwnership cost of a product over its life cycle.

Life cycle—the time interval between a product’s recognition of need or opportunity and its disposal.

Life cycle costing—the process of assessing the cost of a y g p gproduct over its life cycle or portion thereof.

Nominal cost—the expected price that will be paid when aNominal 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 rate—the rate to use when convertingNominal discount rate the rate to use when converting nominal costs to discounted costs. The rate includes a component for general price inflation.

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TerminologyOwnership cost—summation of all operating expenses,

maintenance, support and disposal costs borne by the owner or user of a complete product during its life cycleor user of a complete product during its life cycle.

Product—the result of activities or processes that fulfill a required need A product can be tangible or intangible or arequired 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 cost—the cost expressed in values of the base date, including estimated changes in price due to forecast changes in efficiency and technology excluding generalchanges in efficiency and technology, excluding general price inflation or deflation.

Real discount rate the rate to use when converting real costsReal discount rate—the rate to use when converting real costs to discounted costs. The rate does not include a component for general price inflation.

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What is life-cycle for an asset?

• “The time interval between a product’s 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 andidentification of the need for an asset and terminates with the decommissioning of the asset or any liabilities hereafter”

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What about different perspectives

• Life cycle from a marketing perspective– Introduction – Growth – Maturity – Decline –

• Life cycle from a production perspectiveProduct 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 $ tomorrow9

Time Value of MoneyTime Value of MoneyFuture Value = Present Value (1 + r)n

F = P (1 + r)n

Rearranging

P V l F V lPresent 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 moneyDiscount 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 dProcedure:

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 orthe net present value (NPV) of the investment or project.

CCC n

n

rC

rC

rCCNPV

1..

)1()1( 22

11

0

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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%.

• What’s your answer?

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Quiz questionsQ q

1. What is the present value of $1,050.00 to be received in 1 year’s time with an interest rate of 5%? ($??)1 year s time, with an interest rate of 5%? ($??)

2. What is the present value of $1,102.50 to be received in $2 year’s time, with an interest rate of 5%? ($??)

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)

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Real and nominal discount trates

• 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%

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Jelly Bean exampleJelly Bean example

• I can buy 100 jelly beans for $1 today.

• Consider an inflation rate is 5%. This means that in one year’s 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 year’s ti H i ’ ti I ill b bl t btime. Hence, in one year’s time I will be able to buy:

– 100 x (1.134/1.05) = 108 jelly beansTh 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 beginningg g

• The real rate of interest is the number of extra jelly beans that I can buy in one year’s time if I invest the y y$1 and collect the interest.

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Rate of returnRate of return

• Rate of return r* is a widely accepted index of y pprofitability.

• 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 zerowords the balance is zero.

01)(0

** n n

n rCrNPV

• 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 thisthis.

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Payback

• Investments can be evaluated in terms of how long it will take the system to pay for itself from benefits revenuetake 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 durationestimates of short duration.

• Payback period is the amount of time required for the difference in the present value of savings to equal thedifference 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.

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Graphical Representation of Replacement Decision over Different Intervals

How can we compare the value of two investments one

ReplacePurchase

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 ReplacePurchase

0 1 2 30 1 2 3 4 5 6 7 818

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 andThis 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 CRFCRF [ *(1 ) ] / [(1 ) 1]– CRF = [r*(1+r)ⁿ] / [(1+r)ⁿ – 1]

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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 ithe NPV * CRF however in Blanchard this formula is called the ‘Annual Equivalent Evaluation AE(i). When Blanchard (Section 8 3 6) uses the termWhen 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.

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What is life-cycle costing?

• “A process to determine the sum of all expenses i t d ith d t i l di i itiassociated with a product, including acquisition,

installation, operation, maintenance, refurbishment, discarding and disposal costs ” (AS/NZSdiscarding 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 decisionaccount 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 kiproduct as an input to a decision making or

evaluation process together with other inputs. The cost is based on a defined need associated with thecost 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 managedproduct so that they can be properly managed.

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Use of LCCUse of LCC

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Why is it important?

• Assists companies to eliminate costs before they are yincurred and, to manage some crucial business risks related to costs, cash flow and profitability.

By …

• Making total system cost of an asset/ product visibleg y p

• Highlighting the cost contribution from all phases when making decisions on equipment selection and operationmaking 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 gapproaches, 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 likand the like;

• evaluation and comparison of different approaches for replacement rehabilitation or retirement of ageingreplacement, rehabilitation or retirement of ageing facilities;

• benefit-cost analysis and trade-off studies to determinebenefit-cost analysis and trade-off studies to determine the optimum performance, reliability, maintainability and other requirements;

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Di d li d Discounted costs are applied to …

• selecting amongst competing tenders for products withselecting 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.

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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 DECISIONSSUPPORT POLICIES

IDENTIFICATION OF HIGH COST

CONTRIBUTORS (AREAS OF RISK)

LONG-RANGE PLANNING,

BUDGETING, AND ALLOCATION OF

RESOURCES

PROJECT MANAGEMENT &

CONTROLRESOURCES

Reference: Blanchard, B.S. & Fabrycky, W.J. (2006) Systems Engineering and Analysis, Prentice Hall. Figure D.10

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Ti iTiming

50-70% of the life 5 7cycle cost for a given system can be l k d d i hlocked during the early stages of the life cyclelife 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

fOpportunities for cost savings in the life cyclelife cycle

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Cost element concept 30

Usual costs

The ‘usual’ costs and expenses include

• Capital costs– Buildings and EquipmentBuildings and Equipment

• Expenses Labour Supplies Raw materials Utilities Disposal– Labour, Supplies, Raw materials, Utilities, Disposal

• RevenuesP i d t k t bl b d t– Primary product, marketable by-product

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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 includep

• Capital costsM 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 inspectionskeeping, planning/ studies, training, inspections, labelling, postclosure care, medical surveillance, insurance.

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The IcebergThe Iceberg

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

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S f d t EngineeringSources of data Engineering design data

Management

CMMS data

Reliability data

gplanning data

LIFE CYCLE COST DATA

Logistic

Accounting data

support data

Customer/ Production

dataConstruction

data

Market data

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ExampleExample

• 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 willThis 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 thefactored into the overall costs of maintenance jobs in the future.

• (from M.Cross, UWA Honours 2007)

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Comparison of Option 1 and 2

140001600018000

80%90%100%

300003500040000

80%90%100%

400060008000

100001200014000

Cost

/yr

20%30%40%50%60%70%80%

% o

f tot

al

1000015000200002500030000

Cost

/yr

20%30%40%50%60%70%80%

% o

f tot

al

020004000

s Margin

er cos

tsLa

b, Mat

Part co

sttic

s cos

t

0%10%20%

05000

ss M

argin

wer cos

tsLa

b, Mat

Part co

ststi

cs co

st

0%10%20%

Lost

Gross

Electric

al pow

eCost

for La Pa

Logis

tic

Lost

Gross

Electric

al pow

eCost

for L P

Logis

t

Total Sustaining cost= $ 54,827/yr

Total Sustaining cost= $ 21,493/yrcost $ 54,827/yr cost $ 21,493/yr

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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.

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