When your business buys a product or invests in a new asset, it’s not just the original purchase price that you need to worry about. There are a whole range of other costs that occur over the course of the asset’s useful life that need to be taken into consideration when you decide whether or not to break out the cheque book. Fortunately, that’s exactly why life cycle costing was invented. What is life cycle costing? Find out everything you need to know with our simple life cycle cost analysis definition.
Life cycle cost analysis definition
Life cycle costing (LCC) is the process by which the owners of an asset compile all the costs that this asset will incur over the course of its lifetime. When it comes down to it, life cycle costing isn’t an especially obscure concept, because on some level, everyone does it every time they make a purchase. When you’re thinking about investing in a new car, for example, you won’t just think about the purchase price, but also the running costs, parts replacement costs, insurance costs, and so on.
There are six main costs that you’ll need to think about when learning how to do a life cycle cost calculation. Here’s a little more information about them:
Purchase costs – This is the amount of your initial investment.
Maintenance costs – Essentially, this covers all the costs incurred by your business in ensuring that the asset continues to perform functionally. Depending on the asset, it may include annual check-ups, maintenance fees, specialist professional services, etc.
Operational costs – Although it may sound similar to maintenance costs, operational costs refer to the charges incurred with running the asset itself. This is likely to include items like energy/fuel/water usage, IT services, taxes, and so on.
Financing costs – If you purchased an asset using financing, you’ll also need to take into consideration any interest fees that you paid throughout the course of the asset’s life.
Depreciation costs – It’s also important to consider the extent to which the asset’s value depreciated over its usable life to determine the total cost of the asset.
End of life costs – Finally, you should think about end of life costs, also known as disposal or demolition costs, which may include the charges associated with removal or scrapping.
It’s worth noting that depending on the asset, some of these costs may not apply, and therefore you don’t need to include them in your calculation. For example, if you’re doing life cycle costing for an item that you purchased outright without any outside financing, then you won’t need to calculate the amount of interest you incurred on the purchase. Of course, you’ll also need to minus any salvage or residual value that the asset ends up having.
How to calculate life cycle cost in Excel
Now that you know a little more about the life cycle cost analysis definition, it’s time to get to grips with life cycle costing yourself. There’s no universally agreed-upon formula for working out life cycle costing, as the specific costs are likely to vary depending on the asset. A basic formula that you can use as a starting point is as follows:
LCC = Purchase Costs + Lifetime Maintenance Costs + Lifetime Operating Costs + Financing Costs + Depreciation Costs + End of Life Costs – Residual Value
Of course, you don’t have to calculate life cycle cost manually, as it’s very easy to complete this analysis on Excel, or indeed any other spreadsheet software. Aggregate all the costs associated with a particular asset for each year of its usable life and add them all up (before adjusting for residual value) to work out the total life cycle cost. But don’t just take our word for it – there are plenty of online templates and YouTube tutorials that you can use to learn how to calculate life cycle cost in Excel.
What are the benefits of life cycle costing?
There are a broad range of reasons why life cycle costing can be a major boon for businesses. For a start, it gives you an excellent analytical framework for choosing between two or more assets when you’re making purchasing decisions. Instead of focusing on the initial cost, you can consider the overall costs of different assets, and thereby make smarter investments.
Furthermore, life cycle costing can help make your business’s budgets and financial projections more accurate, as it’s impossible to budget properly if you don’t have an adequate sense of your expenses. For example, if you underestimate cost, you’re going to end up overestimating profit, which could have serious repercussions further along down the line.
Are there any limitations of life cycle costing?
However, there are a couple of limitations of life cycle costing that you should be aware of. Firstly, it’s time consuming. There’s a large amount of data that you’ll need to aggregate throughout the life cycle costing process, and with the need to work out depreciation as well, calculating life cycle cost can become a fairly complex undertaking. It’s also worth noting that in some cases, you’ll need to estimate particular costs and adjust them as you move forward. This may introduce an additional level of uncertainty into your analysis.
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