Friday, March 4, 2011

Life Cycle Cost

What’s the difference between Total Cost and Life Cycle Cost ?

Total cost traditionally only evaluates current costs. For example, a simple total cost model is a “landed cost” analysis in which looks at the price of an item, the costs of shipping, duties, insurance and sometimes cost of money to evaluate items of different suppliers shipping from different locations. Life Cycle Cost analysis does what the name implies - it analyzes the cost over the entire life cycle, which of course would include the total cost factors.

Virtually all items have some level of life cycle cost factors. The simplest electronic component will have a Mean-Time-Between-Failures (MTBF) which will identify the average life of the item before it will fail. The simplest supply item will have a useful life. Items such as a piece of capital equipment or complex software may have multiple Life Cycle Cost factors.

In calculating the Life Cycle Cost of an item you may need to take into account:
·       The useful life of the item.
·       The projected maintenance expense that will be incurred during the life.
·       The cost of maintenance agreements necessary for proper use.
·       The cost of calibration to maintain according to specifications.
·       Any spare parts and repair costs if not part of maintenance agreements or expense.
·       Any operating expenses (expressed in terms of labor, utilities, consumables).
·       Required upgrades.
·       On-going training expenses.
·       Other expenses that could reasonably be expected to occur during the product life including the cost of disposal of the item.
·       Less any scrap or residual value that would exist at the time of trade in or disposal.

Not all Life Cycle Cost factors can or should be a factor in your sourcing decision.

Whether a Life Cycle Cost factor should be are a primary part of your purchase decision will depend upon the specific circumstances surrounding the end use of the item. For example, multiple suppliers may offer items with different reliability. The high reliability (a high MTBF) may not be a deciding factor in your purchasing decision if the customer base is not requiring it or, if there is no benefit or return on the investment to you by purchasing the item with higher reliability. If you were re-selling the product you might agree to pay more for a higher reliability item if you felt you could charge more. If you can’t, all it may be is an extra cost for which their is no return on the investment. As a re-seller you wouldn’t pay extra for an item with higher reliability if the product you make consisted of other lower reliability items and upon failure it is a “throw-away” (where the repair costs exceeds the replacement value). Other items would fail first and the whole product would be discarded providing no value for the one item with extended reliability.

As a re-seller you probably also wouldn’t pay for higher reliability for an item which is planned to be self maintained by the customer or which has a high amount of self maintenance customers as you get no benefit from the extended reliability. On the other hand if you were selling service and maintenance agreements there might be a benefit. 

As the end customer your focus is different and you might be willing to pay more for a product with a longer life or that has reduced operating and maintenance expenses. For example, if you were purchasing building air conditioning equipment for your company the life cycle cost would be important as it impacts your operating and maintenance costs. If you were a real estate developer who would have all the operating and maintenance expenses paid for by the Tenants, the life cycle cost factors may only have value in deciding amongst equal cost suppliers or if you could charge more rent because your space would be more energy efficient.  

Life cycle cost data is used in negotiating price. For high life cycle cost suppliers you argue that the information is important and for them to be competitive they must lower their price since they can’t improve their life cycle cost. For low life cycle cost suppliers you argue that the information is not important and price is the key factor in the decision.

In calculating what a life cycle cost is future payments or costs must be converted into today’s dollars for your decision. The financial term for the analysis is either “Net Present Value” or“ Discounted Cash Flow”. A Discounted Cash Flow analysis identifies what amount would need to be invested today to pay the full amount of an expense in the future taking into account the returns you will have on your investments between now and then. The Net Present Value analysis identifies what the cost of the item is in todays’ money for those payments that are to be made in the future, taking into account the fact that you will be paying for those payments with money that has provided you with a return.

In addition to Life Cycle Cost’s listed above, life cycle costs can also be created by terms.  Here’s a redline example of changes proposed to a software license that was needed in conjunction with the purchase of a piece of capital equipment and the type of life cycle costs it impacted

Supplier grants Buyer a nonexclusive, worldwide, irrevocable, fully paid-up license
This change could potentially allow the supplier to claim additional license fees adding to your life cycle cost. If they can revoke the license your equipment may have no value.  Type of costs: operating cost and residual value

under all intellectual property rights owned or licensable by Supplier at any time
This change could potentially allow the supplier to make other intellectual property claims against the deliverable adding to your life cycle cost ? You want to pay once! Type of Costs: Additional license fees.

to use, modify, repair, or reconstruct the Deliverables (including the right to prepare and have prepared Derivative Works of any software included therein); and to practice and have practiced any process involved in the use of the Deliverables; and to have Buyer Personnel perform any of the foregoing.
This change would require you to only use only the Supplier to do the work. If you don't have pricing for all the possible changes, modifications or repairs,  this takes all your leverage away from negotiating the cost of any of those for the Supplier to do it. If you have the rights, you may have some leverage to drive the Supplier to be competitive.  If you don't have the rights and don't have costs pre-agreed, you can be certain it will drive up your life cycle cost.
Type of Costs: Software Maintanance and changes.

Supplier will provide Buyer the documentation (in addition to that ordinarily supplied to customers) and technical assistance required to exercise the rights granted under this Section on a time and materials basis.
This change makes internal modification, repair or reconstruction more difficult and costly even if you did have the right to do it as you would need to learn it and create documentation on your own driving up the life cycle cost
Type of Costs: Software Maintanance and changes

Deliverables that are determined by Buyer in good faith to be obsolete or surplus may be sold and all licenses necessary to operate such Deliverables will convey with the Deliverables.
Eliminating the ability to resell the equipment with all licenses significantly decreases the residual value of the product increasing your total life cycle cost.  License fees should only need to be paid once.
Type of Costs: Residual Value

Work Made for Hire
All Developed Works belong exclusively to Buyer and are works made for hire. If any Developed Works are not owned by operation of law, Supplier will assign the ownership of copyrights in such Works to Buyer.
Striking the work for hire language eliminates Buyers ability to freely use the materials and could force the Buyer to have to purchase any modification. repair, reconstruction from the Supplier driving up the Life Cycle Cost.
Type of Costs: Software Maintanance and changes

If you see a Supplier making any of these changes,  and there are alternatives always  remind them of the life cycle cost and the impact that will have on your sourcing.  If you don't have alternatives,  and you can't make the objections go away, try to include rates for all the different types of SW people that could be used with escalators over time. Reduce the number of variables you have to negotiate to only the type of people that are required and the number of hours.

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