APPENDIX C
OVERVIEW OF LIFE-CYCLE COST ANALYSIS PROCEDURE

This brief presentation of the principles of life-cycle cost analysis is intended as background for the committee's report. Readers seeking a complete discussion of the topic should refer to the literature. Several of the texts available are cited as references in this report. Readers also should refer to Appendix B (Glossary) of this report.

THE BASIC PREMISE

Life-cycle cost analysis is based on the economic principles of discounted cash flow, which allow the analyst to express the value of money spent at any particular time in terms of an equivalent amount spent at any other time. Using these principles, one may compare the costs of purchasing (for example) an electric battery that will last for 4 years versus purchasing one that will last only 1 year and replacing it three times to obtain 4 full years of service. The principles of discounted cash flow tell the decision maker that unless the cost of the 4-year battery is less than four times the cost of a 1-year battery.39 the 1-year choice is probably better because the total economic costs are lower for the same performance.

39  

All other things being equal and neglecting costs for installation and time out of service, the future costs are simply ''discounted," using the discount rate, to their equivalent present value. The preferred choice is the one with the lowest present value of costs.



The National Academies | 500 Fifth St. N.W. | Washington, D.C. 20001
Copyright © National Academy of Sciences. All rights reserved.
Terms of Use and Privacy Statement



Below are the first 10 and last 10 pages of uncorrected machine-read text (when available) of this chapter, followed by the top 30 algorithmically extracted key phrases from the chapter as a whole.
Intended to provide our own search engines and external engines with highly rich, chapter-representative searchable text on the opening pages of each chapter. Because it is UNCORRECTED material, please consider the following text as a useful but insufficient proxy for the authoritative book pages.

Do not use for reproduction, copying, pasting, or reading; exclusively for search engines.

OCR for page 47
Pay Now or Pay Later: Controlling Cost of Ownership from Design Throughout the Service Life of Public Buildings APPENDIX C OVERVIEW OF LIFE-CYCLE COST ANALYSIS PROCEDURE This brief presentation of the principles of life-cycle cost analysis is intended as background for the committee's report. Readers seeking a complete discussion of the topic should refer to the literature. Several of the texts available are cited as references in this report. Readers also should refer to Appendix B (Glossary) of this report. THE BASIC PREMISE Life-cycle cost analysis is based on the economic principles of discounted cash flow, which allow the analyst to express the value of money spent at any particular time in terms of an equivalent amount spent at any other time. Using these principles, one may compare the costs of purchasing (for example) an electric battery that will last for 4 years versus purchasing one that will last only 1 year and replacing it three times to obtain 4 full years of service. The principles of discounted cash flow tell the decision maker that unless the cost of the 4-year battery is less than four times the cost of a 1-year battery.39 the 1-year choice is probably better because the total economic costs are lower for the same performance. 39   All other things being equal and neglecting costs for installation and time out of service, the future costs are simply ''discounted," using the discount rate, to their equivalent present value. The preferred choice is the one with the lowest present value of costs.

OCR for page 47
Pay Now or Pay Later: Controlling Cost of Ownership from Design Throughout the Service Life of Public Buildings Life-cycle cost analysis is a process of estimating all of the costs likely to be incurred over the economic life of a facility and expressing those costs in terms of an equivalent single value that facilitates comparisons among alternative designs, operating strategies, and external conditions that may influence costs. Life-cycle cost analyses of buildings generally are made to consider whether increased expenditures for construction (e.g., for more durable materials or equipment that uses less energy) are warranted by likely savings in future operating or maintenance costs. Guidelines have been developed for life-cycle cost analysis (ASTM, 1988, for example), but there are no universally accepted procedures that assure that all analyses reflect similar definitions or assumptions. As with most predictive methods, life-cycle cost analysis requires assumptions about the economic life (also termed the time horizon) and the discount rate.40 A longer time horizon will lower the annual savings required to justify an increased initial capital investment and, consequently, the shorter the life of a building, the less worthwhile it is to invest in actions to reduce future operating or maintenance costs. Higher discount rates require larger annual savings to justify an initial capital investment and, consequently, the higher the discount rate, the less worthwhile it is to invest in initial capital costs in order to reduce future operating and maintenance costs. Life-cycle cost analysis specifically requires the consideration of all significant costs of purchasing, owning, operating, and disposing of a facility. Savings are measured as negative costs, and analysts may sometimes include benefits or disbenefits not directly related to the building. Costs are generally classified as recurring or nonrecurring. This classification is useful for applying the appropriate mathematical equations used to compute equivalent values in performing the economic analysis. Funds are typically assumed to be spent at the end of the year in which costs are incurred. However, a comprehensive analysis generally includes all of the following elements: (1) initial capital cost, (2) annual operating cost (energy and maintenance), (3) periodic replacements, (4) additions and alterations, (5) use costs, and (6) salvage value. The single-number result of life-cycle cost analysis is typically either the present value or equivalent annual value of all costs anticipated for the economic life. UNDERLYING ASSUMPTIONS Life-cycle cost analysis is typically applied to a number of alternative plausible designs or management strategies that are generally equivalent except for their different patterns of cash flow during their economic life. The intent of the analysis is to find an alternative that balances initial procurement costs 40   The distinction between interest rate and discount rate is important in economic analyses of this sort. See Appendix B.

OCR for page 47
Pay Now or Pay Later: Controlling Cost of Ownership from Design Throughout the Service Life of Public Buildings and later operations costs to provide satisfactory performance at the lowest life-cycle cost. This analysis depends on several important assumptions. First, there must be plausible alternatives or variations on the design or strategy being considered. These alternatives have to be comparable and more or less equally practical. More specifically, noneconomic performance factors are assumed to be equal or irrelevant for all of the design alternatives. There is no explicit mechanism for considering intangibles that may have a bearing on which alternative is preferred, and the analysis most typically includes only financial costs. All costs (and benefits, if they are included) must be measurable as monetary values to be included in the life-cycle cost computation. Only significant differential costs need to be considered in distinguishing among alternatives. If the alternatives were, for example, building designs being proposed for the same site, the cost of the site would not be included in the analysis. The analysis assumes that there is a free trade-off between initial capital costs and long-term costs. That is, the long-term annual savings that will result from the decision to spend more on a more durable or easier to maintain building can more than offset the extra initial capital cost of that building. Because inflation is common to all alternatives it is usually not considered a differential cost. The life-cycle cost analysis is generally performed using the assumption of constant dollars. As with other economic evaluation methods, the availability and reliability of cost data are significant practical limitations on the value of the analysis results. THE ANALYSIS PROCESS Most life-cycle cost analyses are conducted within the context of the traditional design or problem-solving process: (1) define objectives, (2) identify alternatives, (3) define assumptions, (4) project benefits and costs, (5) evaluate alternatives, and (6) decide among alternatives. The estimated life-cycle cost of each alternative is one of the several factors typically considered in evaluating and deciding among alternatives. Many building-related life-cycle cost studies focus on improving the performance of specific building components likely to be most susceptible to trade-offs between construction and operation and maintenance activities, for example, HVAC (heating, ventilating, and air conditioning) systems. Defining objectives includes defining such a focus (which may be the building as a whole), identifying the people in an organization who will be affected by the study (and who should therefore be involved), and developing clear and measurable criteria for judging the effectiveness of suggested alternatives. It is important to state the study objectives in such a way that they do not limit solutions. While the focus of a life-cycle cost analysis may be on the cost implications of various technical design decisions, it is important to consider the impact of building design decisions on the organization. In some situations

OCR for page 47
Pay Now or Pay Later: Controlling Cost of Ownership from Design Throughout the Service Life of Public Buildings potential problem solutions may require more than the replacement of a building component, and it will be important to identify those individuals who would be affected and include their perspectives in the analysis. Life-cycle cost analysis focuses on evaluating and comparing alternatives, but it provides no guidance as to how alternatives should be generated. The ability to develop appropriate alternatives is a function of the creativity of the design and management team. However, two criteria can guide the search for alternatives within a life-cycle cost context: (1) alternatives should represent a range of possible solutions to the identified problem; interdisciplinary teams are often helpful in meeting this criterion because of the members' different backgrounds and experiences; and (2) because life-cycle analysis is limited to financial and economic factors, the alternatives being compared should have approximately the same characteristics of performance. The alternative with the lowest total life-cycle cost is typically preferred. However, other criteria such as risk minimization, corporate image or public role of the building, ease of implementation, and other judgmental factors can become a significant part of the selection process. Because of the uncertainty associated with estimating the future, sensitivity analysis of life-cycle cost estimates is essential to test the effects of changes in such critical parameters as the discount rate and timing of major operation or repair expenditures. Sensitivity analysis is typically undertaken at the end of the analysis process, to confirm that the conclusions would remain valid if different, but still reasonable, assumptions had been used. APPLICATIONS Life-cycle cost analysis has typically been used to evaluate building design alternatives from a particular and limited technical perspective. For example, energy for heating, air conditioning, and lighting accounts for a large share of operating costs and has therefore been the focus of research on strategies for minimizing life-cycle energy costs through investments in energy-saving equipment. However, life-cycle cost analysis could have much broader application within a context of business productivity. Facilities-related costs are typically a small fraction of the costs associated with economic and social activities that buildings house, but the influence of a building's performance on these activities can be substantial. If the ventilation system does not work effectively, for example, a building's occupants may suffer health problems, resulting in declining production, lost work time, and health care expenses. Failure of a roof may lead to costly damage to the contents of the building. Life-cycle cost analysis may also be used to assess the impact of the building's design on an enterprise, taking into account such costs as staff salaries, lost construction time, fire insurance, and lost revenues due to down time. Some researchers have explored these relationships, and some major industrial corporations consider them in making decisions about facilities, but data and analysis tools

OCR for page 47
Pay Now or Pay Later: Controlling Cost of Ownership from Design Throughout the Service Life of Public Buildings are not yet available to support this broader application of life-cycle cost analysis. Reference ASTM (American Society for Testing and Materials), 1988, Standard Guide for Selecting Economic Methods for Evaluating Investments in Buildings and Building Systems , E 1185–87, ASTM, Philadelphia, PA., January.

OCR for page 47
Pay Now or Pay Later: Controlling Cost of Ownership from Design Throughout the Service Life of Public Buildings This page in the original is blank.