MANAGEMENT ACCOUNTING - PERFORMANCE EVALUATION

Bob Scarlett explains the concept of life-cycle costing and discusses its applications in investment decision-making and financial control.
The idea behind life-cycle costing (LCC) is simple enough. When calculating the cost of some activity - for example, developing a new product or installing a new IT system - it's important to consider not only the initial cost but also the total cost to be incurred over the lifetime of that product or system. The lifetime cost is likely to include equipment maintenance, the replacement of parts, staff training, system upgrades and so on. The cost of doing anything is rarely a one-off, up-front expenditure. More commonly, undertaking some action involves a continuing commitment over the whole life of the action and its outcome. LCC is a financial concept that has applications in strategy, decision-making, performance evaluation and management control. It forces managers to face the full consequences of actions that they have undertaken or are considering. In common with most other modern management techniques, it has been criticised. For example, Jim Seymour wrote in PC Week (September 1989) that LCC was being "used by hardware and software vendors... as a kind of now-you-see-it, now-you-don't sophistry to 'prove' that something that looked outrageously expensive wasn't really so pricey after all". But the wider view is that assessing what something truly costs other than on a life-cycle basis is a fiction.
The following simple example shows how LCC analysis can be applied to decisionmaking. Consider the purchase of a new truck, which will be required to travel 50,000km a year. Two suitable models are available: the Trubrit and the Kamikaze. The Trubrit is priced at £36,000 and has a life of six years. Its running costs are 15p per km in the first year, rising by 3p per km in each successive year. The Kamikaze is priced at £20,000 and will last four years. It requires a new engine costing £5,000 to be fitted at the end of the second year and has running costs of 20p per km in year one, rising by 5p per km in each successive year. The "cost of money" is 12 per cent. Which truck should we buy?
This is an LCC analysis problem. Our decision may be guided by calculation of an annualised equivalent cost (AEC) for both options (see table, left). The AEC is an equal annual amount paid at the end of each year that gives the same net present value (NPV) as the cost profile for the option over its whole life-cycle. In the Trubrit's case, the option AEC is the NPV (£80,231) divided by the six-year cumulative discount factor taken from annuity tables (4.111). In the Kamikaze's case, the relevant NPV (£64,678) is divided by the four-year cumulative discount factor.
The key point to note here is that, although buying the Trubrit involves the greatest initial expenditure, it turns out to be the best option when the whole life-cycle costs of the two alternatives are considered.
This example illustrates the proposition that the initial cost of doing something is usually far less than the future costs that you must commit yourself to paying. With the Trubrit, you pay £36,000 initially, but are then committed to paying a further £67,500 over the next six years.
In the case of product design it is usual for 80 per cent of a new product's lifetime costs to be committed at the moment it leaves the drawing board - and that's before any actual production costs have been incurred. This gives rise to the saying that good design is cheap and the cost of bad design only becomes apparent late in a product's life cycle.
The truck example can also be used to illustrate the control dimension of LCC. In buying capital equipment and making other business decisions, the full cost of doing something is often properly controlled only at the point of the decision. After that point, control over costs rarely amounts to more than monitoring expenditure. For example, the running costs of a Trubrit may be submerged into the category of general overheads. The effective cost control of activities such as IT operations, premises maintenance or transport services can be impossible using conventional management accounting systems.
Under an activity-based costing system, such activities are identified separately and associated costs are collected and reported. Furthermore, it may be possible to split individual activities into life-cycle phases. In this way, activity costs can be reported under life-cycle phase categories and compared with relevant benchmarks to assess performance.
In the Trubrit's case, the performance cost benchmark would be higher for the later stages of its life-cycle. Note that the forecast running costs for year six are double those for year one. If you are told that the actual running costs incurred for the activity of operating a Trubrit in one particular year are £10,000, then you cannot judge whether this is a good or bad performance unless you know where in the life-cycle it falls. If performance benchmarks don't distinguish between different phases in the life-cycle, meaningful cost control is impossible.
LCC is often described as an activitybased technique. Academic accountants have recently popularised the use of the term activity-based life-cycle costing. The wider concept of LCC has influenced policy in many areas of management in both the public and private sectors. For example, the term "whole-life costing" is often used in the design of public-private partnership (PPP) projects. A 2002 government publication on the subject offered the following advice: "Take the long-term view - remember the whole-life cost of the project and specify the outcome you want to achieve."
Procurement practice in the public sector traditionally separated the construction of a facility from its operation. If the government wanted a new prison, school or hospital, it would prepare a specification for its construction and invite contractors to tender, usually accepting the cheapest bid. Once built, the facility would be handed over to the government, which would make separate arrangements for Its operation. This approach had one main problem: the successful contractor was incentivised to build the facility at the lowest possible initial cost, but It might not be too worried about the long-term operating costs. The design of a school entails detailed decisions that affect its future heating, lighting, furnishing and maintenance costs. The contractor may compromise on these in order to minimise its construction costs. The PPP approach requires the contractor's long-term involvement. Typically, the specification is for service delivery over the life of the facility (ie, output), rather than for its initial cost (input). The contractor will build the facility and continue to own and maintain it while charging the government rent. In its extreme form, such an arrangement might involve a contractor building a prison and then operating it on behalf of the government.
The long-term, integrated nature of PPP service contracts encourages contractors to consider the relationship between the design of a facility and its whole-life operating costs. LCC analysis is an essential element in a variety of modern management practices, of which PPP is only one example.
P1 further reading
R Booth, "Life-cycle costing - activity-based costing examined", Management Accounting, June 1994.
Life Cycle Costing, The Office of Government Commerce (http://snipurl.com/1t0az).
Green Public Private Partnerships, The Office of the Deputy Prime Minister (http://snipuri.com/1t0b4).
Bob Scarlett is an accountant and consultant.
Copyright Chartered Institute of Management Accountants Dec 2007/Jan 2008Provided by ProQuest Information and Learning Company. All rights Reserved (www.proQuest.com)