With any piece of equipment, there’s a lifecycle cost (LCC), which is the total cost incurred over its entire lifespan, encompassing purchase, installation, operation, maintenance and disposal. Calculating LCC requires a systematic approach to identify and quantify all elements of the LCC equation.
Lifecycle cost analysis highlights the most cost-effective option based on the available data. Many organizations focus solely on the initial purchase and installation costs of a system, however, it is essential for plant managers to assess the LCC of different options before installing significant new equipment or undertaking major overhauls.
Although mostly overlooked, including the inflation rate and interest rate (discount rate) in LCC analysis is crucial for an accurate financial assessment of projects, assets, or investments over their lifespan. This article explains how to effectively include both inflation and interest rates in the LCC analysis using a spreadsheet.
Understanding Inflation Rates
The inflation rate represents an increase in prices over time, affecting the future cost of goods and services. Incorporating inflation into LCC analysis is essential for:
- Realistic Future Cost Estimation: Inflation adjusts costs (e.g., maintenance, replacement and operational expenses) to reflect their real value in the future, preventing underestimation.
- Budget Planning: Accounting for inflation ensures adequate budgeting for future expenses, avoiding funding shortfalls.
- Comparability: Inflated future costs provide a realistic comparison between options when evaluating long-term projects or investments.
Example:
A maintenance cost of $1,000 today may rise to $1,480 in 10 years at a four percent annual inflation rate. Ignoring inflation would lead to incorrect financial planning.
Understanding Interest Rates
The interest rate or discount rate represents the time value of money—how future cash flows are valued in today's terms. Using a discount rate in LCC analysis is critical for:
- Present Value Calculation: Future costs are "discounted" to their present value, allowing for a fair comparison of costs occurring at different times.
- Time Value of Money: Money has different values over time due to earning potential. Today, the dollar is worth more than a dollar in the future, and the discount rate quantifies this difference.
- Optimal Decision-Making: Discounting helps identify the most cost-effective option by evaluating total costs over the lifecycle in today's terms.
Example:
A $1,000 cost ten years from now, discounted at eight percent, is worth approximately $463 today. Without discounting, the analysis would incorrectly value this future cost at $1,000.
The Combined Importance of Inflation and Interest Rates
By incorporating both inflation and interest rates, LCC analysis achieves:
- Accuracy: Reflects real-world financial conditions;
- Comparability: Balances rising costs (inflation) against the diminishing value of money (discounting);
- Informed Decision-Making: Identifies the most financially sound choice over the lifecycle of a project or asset.
Ignoring these rates can result in overestimating or underestimating costs, leading to flawed investment or project decisions.
The Calculation
To calculate the LCC of a machine, you would use the present value (PV) formula for each year's cost:
- C0 = Total annual cost + salvage value
- Ct = Cost in year t (adjusted for inflation)
- i = Discount rate
- t = Year
- n = Total number of years
- f = Inflation rate
Follow these steps to calculate the lifecycle cost:
- Adjust the annual cost for inflation for each year.
- Discount the inflated costs to their present value.
- Sum the discounted costs to get the total lifecycle cost.
Key Components of an LCC Analysis
The formula for lifecycle cost analysis is:
LCC = Cic + Cin + Ce + Co + Cm + Cs + Cenv + Cd
The key components of LCC analysis typically include:
LCC = lifecycle cost
Cic = initial costs, purchase price (e.g., pump, system, pipe, auxiliary services)
Cin = installation and commissioning cost (including training)
Ce = energy costs (predicted cost for system operation, including pump driver, controls and any auxiliary services)
Co = operation costs (labor cost of normal system supervision)
Cm = maintenance and repair costs (routine and predicted repairs)
Cs = downtime costs (loss of production)
Cenv = environmental costs (contamination from pumped liquid and auxiliary equipment)
Cd = decommissioning / disposal costs (including restoration of the local environment and disposal of auxiliary services)
LCC Analysis Case Study
This case study focuses on conducting a lifecycle cost analysis for a piping system, specifically targeting a control valve. The system involves a pump that transfers a process fluid to a pressurized tank. A control valve maintains a flow rate of 80 cubic meters per hour (m³/h), 350 gallons per minute (gpm), into the pressurized tank.
The plant engineer has been facing recurring issues with a fluid control valve (FCV) that fails every 10 to 12 months due to erosion caused by cavitation. Each failure incurs a repair cost of $4,000. To address the problem, replacing the current valve with a cavitation-resistant model is under consideration. However, before proceeding, the project engineer decided to explore alternative solutions and perform an LCC analysis, considering an eight-year life, to identify the most cost-effective option.
The four options proposed are:
Option A – Install a new control valve designed to handle the high-pressure differential.
Option B – Trim the pump impeller to reduce the pump's head, thereby decreasing the pressure drop across the existing valve.
Option C – Install a variable frequency drive (VFD) and eliminate the flow control valve. The VFD would regulate the pump speed to achieve the required process flow.
Option D – Maintain the current system and plan for annual repairs of the flow control valve.
Here’s how to perform an LCC analysis that includes inflation and interest rates:
Step 1 – Determine the power consumption calculation using pump curve for Option A
ρ = Density of water (1000 kg/m3 for water)
g = Gravitational acceleration (9.81 m/s2)
H = Head (71.7 m)
Q = Flow rate (80 m3/Hr)
η = Pump efficiency (75.1%=0.751)
Step 2 – Apply the power consumption calculation for all four options using pump curve
Step 3 – Determine the energy cost / year calculation for all options
Step 4 – Calculate the total annual cost + salvage cost calculation for all four options
Step 5 – Apply the interest rate and inflation rate for all four options (See formula below and highlighted formulas at the top of each spreadsheet for Option A)
- C0 = In this case, total annual cost + salvage value
- Ct = Cost in year t (adjusted for inflation)
- i = Discount rate (8% in this case)
- t = Year (from 1 to 8)
- n = Total number of years (8 in this case)
- f = Inflation rate (4% in this case)
Step 6 – Apply the same principles for all options and compare the present lifecycle cost values
As you can see from the spreadsheets below, after applying net present value principles and considering interest and inflation rates, Option B (trim the pump impeller to reduce the pump's head, thereby decreasing the pressure drop across the existing valve) is the most cost-effective option.
