Week 1: A Total Cost Approach

1. Week 1:A Total Cost Approach

2. Key Points • Total Cost Approach • Terminology • First Generation Technique • Second Generation Technique • Third Generation Technique • Life-Cost Studies

3. 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

4. Terminology • Life-cost (preferred) • Life cycle cost (most common UK and US) • Costs-in-use (original term) • Operational cost, running cost, total cost analysis • Occupancy cost, functional-use cost • Ultimate cost • Terotechnology , whole-of-life cost • Recurrent cost

5. First Generation Technique • Although 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

6. Second Generation Technique • The 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

7. Third Generation Technique • While 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

8. 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

9. Sustainable Development • Background • Economic Interaction • Intergenerational Equity • Resource Usage • Building Projects • Evaluation Requirements

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. Life-Costs • Definition • Purpose • Relative Importance • Past Reasons for Ignoring • Other Disadvantages • New Imperatives • Characteristics of Life-Costs

17. 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

18. 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

19. 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”

20. Past Reasons for Ignoring • Uninformed client • Changes in the relative importance of energy and labour costs over the past few decades • Separation of capital and operating budgets • Lack of historical data and standards • Time constraints during project documentation • Complex nature of buildings and service systems • Concentration by consultants on services in demand rather than new markets

21. 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 conditions • Long time lag between design and performance feedback • Reservations about long-term predictions • Taxation changes and implications

22. 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

23. Characteristics of Life-Costs • The 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

24. Practice Issues • Implementation Strategy • Procedural Steps • Discounting Philosophy • Risk Analysis • Education and Marketing

25. 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

26. Procedural Steps • Establish the objective • Determine the choice of alternatives • Formulate assumptions • Identify the time horizon for the study • Estimate all the costs over the life • Compare costs and rank the alternatives • Undertake risk analysis • Investigate capital cost constraints

27. 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

28. 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

29. 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