Life cycle costing. Advantages, disadvantages and criticism of this procedure

Table of Contents

Introduction

Functions of LCC

Discussion of LCC

Conclusion

References

Introduction

Sustainability is developing in as important target for an increasing number of industries and governments. Especially in a faster moving world, which is determined by quarterly period reports, a long term orientation can be a competitive advantage for unlisted companies. In the 1960´s by the US Department of Defense began to develop a tool to handle increasing costs. They recognised that the purchase price was not the only important criteria. Training or maintaining costs had to be considered for the total cost calculation, too. However, several definitions of Life cycle costing (LCC) exist that tend to be similar: ’monitoring the cost incurred throughout a product’s life cycle’ (Woodward, 1997) or ‘LCC is the sum of all costs incurred during the life cycle of a building, system or product. It includes the costs of the project, development, acquisition, operation, conservation and maintenance and salvage value if it exists.’ (Goralczyk, and Kulczycka, 2005). In the following essay several functions of life cycle costing will be drawn up. Furthermore, advantages, disadvantages and criticism of this procedure will be analysed.

Functions of LCC

LCC is a methodology which is used to provide a more comprehensive view of costs.

Figure 1 shows the relationship between LCC, Full Cost Accounting and Total Cost Accounting.

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Figure 1: Alternative Cost Accounting Methods

Source: Cole, Sterner, 2000

Thereby all initial and working expenses are summed up into one economic figure. In addition the tool offers the possibility to contrast investments from the very beginning to the end. Future costs are discounted back to the present to make it comparable and therefore allows the evaluation of these alternatives (Cole, Sterner, 2000). That means that by using LCC a company gets the possibility to influence future product costs, for instance through modification of the use of the product itself, at a very early stage. LCC enables firms to comprehend the interaction of different materials or other cost items during the whole life cycle process. As an example engineers increase the durability of a machine but in return the cost for higher quality materials could increase. Hence, through these circumstances a broad and specified analysis of causes and effects can take place. Provided with this total overview of life cycle costs, further savings and optimisations like outsourcing are possible.

Consequently the focus of the costing system changes with the life stage of the product. An organisation with a product at an early development stage will use LCC as a planning tool. However, a product in a mature stage needs more to be controlled than to be planned. The kind of control varies from enterprise to enterprise. One organisation will estimate the control of actual and budgeted costs, others will rate the understanding of costs related to environmental effects higher. Together with profitability assessment and the facilitating of decisions, the importance of these objects fluctuates over the different phases (Dunk, 2004). To fulfil these claims LCC can not be a static accounting tool, it should be more interpreted as a dynamic framework which delivers the right information for decision makers at altered life cycle periods. Figure 2 shows the shift of tasks in detail.

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Figure 2: Change of Focus during a Product Life Cycle

Source: Lindholm and Suomala, 2007

To handle the constant change the financial department must be connected with other departments to request the required data. At the beginning several alternatives have to be ranked and compared. Afterwards the economical impact has to be evaluated and the needed resources have to be planned. In the middle of the life cycle the planning of the optimal utilisation and cost management are more in focus. The plans for potential expenses are based on the actual costs. Furthermore, the reasons for wrong estimations should be researched and this knowledge should be invested in more precise predictions. Also, the costing practices should be modified to react to environmental changes. In this phase the planning of the optimal life cycle length is necessary to gain maximum profit of the product. Towards the end product related cost calculations together with an overall report of the goods should be created. With this data the divergences to the strategy can be clarified. Hence, an evaluation of the total impact of the product to the organisation can be made. Also the facts are a good basis for future products which are in development and can help to estimate environmental changes early enough.

All in all LCC enables companies to get a complete picture about the total product life. Through the overview of historical costs, the actual cost behaviour and the estimation of future costs, firms should be able to use this knowledge for future products to gain a competitive advantage. Therefore, the LCC is an important support for the development of different strategies (Lindholm and Suomala, 2007).

Discussion of LCC

The following discussion includes what benefits and disadvantages of LCC exist in theory and practice. Several hurdles, together with potential solutions for the implementation, are drawn up.

In practice the first critical point for an implementation of a LCC-tool is the understanding of the employees. At the beginning this kind of cost evaluation seems to be very unclear and without real guidelines. Furthermore, the already known benefits are not convincing enough. The first doubt is the lack of experience in predicting the future. How can the company trust in the forecast when the changes in the environment happen faster than ever before? For this reason companies tend to use the acquisition and starting costs. Hence, they are determinant, easy to calculate and reliable. Due to these facts, different options can be compared and are the foundation for decision making. In addition many corporations are forced by shareholders to be as profitable as possible. The quarterly report is important for most companies and therefore they tend to be short-term orientated. A justification of an investment on the basis of initial costs is easier than explanation of several assumptions for the future. However, significant problems may emerge. Maintenance, operation and disposal costs are neglected and complex to predict. Thus, with a total LCC calculation, firms can save money and be more profitable. Also, there is the danger that the investment does not match the long term strategy of the organisation (Arditi and Messiha, 1996).

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