Week 1:A Total Cost Approach

Key Points

Total Cost ApproachTerminologyFirst Generation

TechniqueSecond Generation

TechniqueThird Generation

TechniqueLife-Cost Studies

Total Cost Approach

Commonly the measurement of costs is undertaken on a capital cost basis

The total cost approach takes into account both capital and operating costs so that more effective decisions can be made

Concern that evaluation based on capital costs alone may lead to society paying more for its buildings than the theoretical optimum

Still not widespread use in many countries

Terminology

Life-cost (preferred)Life cycle cost (most common UK and US)Costs-in-use (original term)Operational cost, running cost, total cost

analysisOccupancy cost, functional-use costUltimate costTerotechnology , whole-of-life costRecurrent cost

First Generation TechniqueAlthough the idea of discounted cash flow

analysis has been around for over a century, the total cost approach for buildings was first seriously proposed in 1960 (Stone)

The reason for its interest was that in the UK there was concern at this time over the maintenance burden of the country’s aging stock of buildings

Maintenance was therefore behind the first generation use of the technique

Second Generation TechniqueThe technique was often discussed and

advocated but never became common practice

It took the world oil crisis of the 1970s to revitalise interest in the technique, particularly as there was great concern that the enormous increases in fuel prices could not be afforded in the future

Energy conservation was therefore behind the second generation use of the technique

Third Generation TechniqueWhile the technique became popular in the

US, mainly due to legislation, most other countries lost interest again as world oil prices stabilised

In the late 1980s the need to use non-renewable resources in a sustainable manner renewed interest in the technique as a means of measuring building performance

Environmental protection is driving the third (current) generation use of the technique

Life-Cost Studies

Total asset management must be seen as the ultimate bounds of the life-cost technique

This involves project initiation processes, investment analysis, project management and facility management

Life-cost studies are vital to total asset management and will become common practice as governments become more concerned over resource usage and sustainability

Sustainable Development

BackgroundEconomic

Interaction Intergenerational

EquityResource UsageBuilding ProjectsEvaluation

Requirements

Background

Over the last decade there has been worldwide consensus on the need for ecologically sustainable development (ESD)

Alarming realisations about the rate of depletion of the natural environment in terms of resource extraction and waste disposal have caused a groundswell of public and political interest

Attitudes are changing, but this change needs to occur at a faster rate

Economic Interaction

Development implies change, and should by definition lead to an improvement in the quality of life of individuals

Development encompasses not only growth but improvements in utility and well-being and the transformation of natural resources into productive output

Therefore the environment and the economy necessarily interact

Intergenerational Equity

Sustainable development is the balance between economic progress and environmental protection

The notion of sustainable development places clear emphasis on intergenerational equity

In other words, future generations should not be worse off than present generations and any development should be consistent with such long-term objectives

Resource Usage

Sustainable development implies using renewable natural resources in a way which does not eliminate or degrade them or otherwise decrease their usefulness to future generations

It also implies using non-renewable natural resources at a rate slow enough as to ensure a high probability of an orderly societal transition to new alternatives

An increased value for the environment is needed

Building Projects

Development is undeniably associated with construction and the built environment

Natural resources are consumed by modification of the land, manufacture of materials and systems, the construction process, energy requirements and waste products of operation

Building projects are a major contributor to both economic growth and environmental protection and hence are concerned with sustainable goals

Evaluation Requirements

When evaluating buildings due consideration should be given to all the costs and benefits that flow from the decision over its life

Past analyses have concentrated on capital costs

The effects of subsequent operating costs are often completely ignored

Yet there is evidence to suggest that operating costs far outweigh capital costs over a building’s economic life

Life-Costs

DefinitionPurposeRelative ImportancePast Reasons for

IgnoringOther DisadvantagesNew ImperativesCharacteristics of

Life-Costs

Definition

Life-cost is the total cost of creating and maintaining an asset over a specified time horizon

Life-cost includes expenditure related to capital, operating and finance that may occur during the period of financial interest of the owner

It is applied to buildings and building components, but the technique is equally applicable to any asset

Purpose

Life-costs identify the total cost commitment for the acquisition of any asset

They facilitate an effective choice between alternative methods of achieving a stated objective

A life-cost approach is a management or planning tool that details current operating commitments

It identifies areas in which operating costs may be reduced, either by usage or system design

Relative Importance

Initial costs are clear and visible at an early stage, whereas life-costs are not

Longer term costs can far outweigh initial costs and should have a much stronger influence on decisions than is currently the case

It is increasingly important for QSs to offer total cost advice and become proficient in life-cost methods upon which such advice is based

Capital costs are often just the “tip of the iceberg”

Past Reasons for Ignoring

Uninformed clientChanges in the relative importance of energy

and labour costs over the past few decadesSeparation of capital and operating budgetsLack of historical data and standardsTime constraints during project documentationComplex nature of buildings and service

systemsConcentration by consultants on services in

demand rather than new markets

Other Disadvantages

The diverse nature of the industry’s clients and their motivations

The complex and theoretical relationship between money now and money in the future

Frequently changing economic conditionsLong time lag between design and

performance feedbackReservations about long-term predictions Taxation changes and implications

New Imperatives

There is no longer any doubt that the construction industry must take account of the long-term implications of current design decisions

The relative balance between fixed (initial capital) costs and variable (operating and finance) costs has changed

Labour and energy costs will continue to rise (limited natural resources ensures this)

Need to get involved in the early stages of design

Characteristics of Life-CostsThe major technical characteristics of the

analytical tools on which comparative life-cost studies are based has long been recognised

Life-costing represents a particular application of a classic financial technique called discounted cash flow analysis

This technique enables the time-phased costs and benefits of a project over a specified period to be evaluated on an equivalent basis

Practice Issues

Implementation Strategy

Procedural StepsDiscounting

PhilosophyRisk AnalysisEducation and

Marketing

Implementation Procedure

Identify the overall time period (life) for the study, given that different components may have different lives

Consider all costs by time period (ie. initial investment, running costs and replacement)

Adjust for the effects of time on the value of money received or spent

Undertake risk analysis to manage the uncertainty of future events

Procedural Steps

Establish the objectiveDetermine the choice of alternativesFormulate assumptions Identify the time horizon for the studyEstimate all the costs over the lifeCompare costs and rank the alternativesUndertake risk analysis Investigate capital cost constraints

Discounting Philosophy

Discounting is a means by which an equivalent (abstract) value is determined

Costs and benefits which arise in different time periods must be brought to a common base so that a proper comparison can be made

Discounting is merely a technique invented to help make judgements between investments that have different timings of costs and benefits

Discounting used for comparative purposes only

Risk Analysis

Forecasting possible events is normally an integral part of the decision-making process

It is also the subject of considerable uncertainty and exposure to risk

Discounting and life-cost studies are clearly reliant on appropriate forecasts of future events

The only way to overcome the difficulties associated with forecasting the future is to manage the risk through a risk analysis process

Education and Marketing

Techniques need to be better communicated to the industry as part of continuing professional development

Clients need to be made aware of the advantages that life-cost studies can provide

Government authorities need to take a leading role in development of guidelines and standards

Research is necessary to objectively identify the financial benefits