WHOLE LIFE COSTING

General Principles

This guide introduces the following general principles of whole life costing.

Essentially, whole life costing is aimed at answering the question “What is the cost ofachieving this objective in this way?” rather than the more limited question “What isthe cost of buying this item?” However, this question will be relevant at many stagesthroughout the procurement process – from consideration of the initial business caseto evaluation of tenders.

In deciding on which option to select for meeting a need or providing a service, it isessential to consider all the costs involved in each option.

♦ Some of these costs will be incurred at the outset, when equipment is bought orinitial payments are made for service contracts. However, many of the costs willonly arise over the life of the option, for example, as a result of running costs,including energy costs, equipment maintenance costs, staff training and disposalcosts of both the old equipment and the new equipment at the end of its workinglife.

♦ It is important to think in terms of meeting identified needs rather than in terms ofacquiring particular assets (eg lease versus buy). When deciding how to meet aneed, the options considered should include all the practicable ways of meetingthat need. An item which has ordinarily been used to achieve this may notactually be essential for meeting the objective.

♦ Cost is not usually the only criterion on which the different options should beevaluated. There will also be considerations of the quality of the product or theservice provided. Sometimes there will be minimum quality standards to be met.In other cases, different solutions will offer different advantages. Some of theseadvantages will relate to quality and others will relate to cost.

♦ Costs arising from impacts on the environment, such as clean-up costs, may formpart of the cost in the initial business case. This will then be reflected in thespecification.

♦ Environmental issues must be taken into consideration in the business case andspecification, independently of costs, for example to meet the Executive’s policyand objectives on environmental issues, particularly where there is cleargovernment policy, such as on paper or timber purchases or a clear Executivepolicy.

♦ Further guidance on environmental policy in procurement can be found at:

http://www.scotland.gov.uk/about/FCSD/PCSD-POL/00017839/susdevguide.aspx1. Introduction

This guide explains the concept of whole life costing, its purpose and its place inpurchasing decisions. Although the guide is primarily aimed at public sector bodies,the principles of whole life costing are the same for all organisations, whether publicor private sector.

Essentially, whole life costing is aimed at answering the question “What is the cost ofachieving this objective in this way?” rather than the more limited question “What isthe cost of buying this item?” However, this question will be relevant at many stagesthroughout the procurement process – from consideration of the initial business caseto evaluation of tenders.

The cost of achieving an objective differs from the cost of buying an item in twoways. First the purchase of goods may not be necessary to the achievement of theaims identified. For example, they may be available for hire or a different good maydo the job just as well. Second, the purchase price is unlikely to be the only costincurred as a result of the procurement. For example, there may be fuel costs andmaintenance costs and there may be a cost incurred on disposal.

Determining the full cost of a method of meeting a given requirement involves anunderstanding of how the eventual solution will be implemented. It is alwaysnecessary to consider what the procurement is supposed to provide, the cost of thesolution and the relative costs of meeting the requirement in other ways.

Although whole life costing deals with the cost of the requirement over its total life, itshould be remembered that different solutions may have different life spans. Thecost of the chosen solution should therefore be annualised to enable the costs ofdifferent solutions to be properly compared (such issues can arise either at the initialbusiness case or at the evaluation stage).

For example, a bus with automatic transmission which has a whole life cost of£270,000 and a life span of 15 years has an annual cost of £18,000. A bus withmanual transmission which has a whole life cost of £200,000 but a life span of only10 years has an annual cost of £20,000. The bus with the higher whole life cost hasthe lower annual cost.

The life span of a solution will, of course, depend on the length of time the solutionis needed as well as its durability. In the above example, if the bus was only neededfor 10 years and the total cost of using the bus with automatic transmission for thefirst 10 years would be £210,000, the bus with manual transmission would deliverbetter value for money.

2. The Full Cost of Using an Item

The cost of using an item can be broadly divided into three categories: acquisition,running and disposal costs. Acquisition costs are incurred before the solution isready for implementation. Running costs are incurred as a result of actually using itor keeping it available. Disposal costs are incurred on disposal or when dealing withsite contamination or other harmful effects. There may also be some income that willbe realised on disposal if there are assets with a resale or residual value. This and

any rental income when assets are not in use can be offset against the costs indetermining the whole life cost.

Figure 1 provides some examples of each of these types of cost1, although this is notan exhaustive list.

2

1 Some of these may not be admissible as cost criteria in public sector procurement procedures, as they may givean unfair advantage to an existing supplier or contractor.

Purchaser’s Legal Costs Cost of Writing SpecificationPurchase Price/Rent/Hire Purchase Software LicencesFees to Copyright Holders One-off Operator’s Licence FeesCost of Transportation to Site Installation CostsPreliminary Inspection Costs Sustainable Development Costs

Insurance AccommodationAnnual License Fees Operatives’ Wages and SalariesFuel and Electricity Cleaning CostsPeriodic Inspection Costs Spare Parts and Other Maintenance CostsSustainable Development Costs

Seller’s Legal Costs Costs of Removing InstallationsCost of Transportation from Site Refuse Disposal ChargesSite Clean-up Costs Sustainable Development Costs

Figure 1Costs of Ownership

3. Whole Life Costing and Value for Money

Whole life costing must be used in the context of the need to obtain value for money(vfm) in public sector purchasing decisions. Cost alone, even whole life cost, doesnot capture all of the information relevant to a purchasing decision. Value for moneydoes not simply mean selecting the cheapest option which meets the minimumrequirements but is defined as “the optimum combination of whole life cost andquality (or fitness for purpose) to meet the customer’s requirement”.

Price will usually be only one of a number of criteria used to evaluate tenders andtherefore whole life cost and quality should be used to determine the value formoney of each option. The detailed criteria should be published in the contractnotice and contract documents, to ensure that all potential bidders have equalaccess to full information about the tendering procedure, including the evaluationcriteria to be applied, and to enable them to improve the quality of their bids byadapting them to the actual requirement. The criteria for deciding which delivers thebest vfm (in EC terms: most economically advantageous tender) include quality,price, period for completion, running costs, profitability and technical merit.

In cases where there is a range of acceptable quality, a formal scoring systemshould be used to allow an objective and informed decision to be made. This islikely to involve giving each option a score for each criterion and then multiplyingeach score by a weighting factor reflecting the relative importance of the respectivecriterion. This is explained more fully in the Bid Evaluation section of the ScottishProcurement Toolkit.

4. Environmental Costs

Another aspect of whole life costing at initial business case stage is that not all thecosts of using an asset or of receiving a service are borne by the user of the asset orservice. There may be damage to the environment the cost of which is borne byneither the provider nor the user of the asset or service. The European Commissionhas issued guidance3 on the possibility of taking account of environmental criteria inthe procurement of supplies, works and services, Commission of the EuropeanCommunities, Commission Interpretative Communication COM(2001) 274(Final),2001 www.europa.eu.int.

It is important to understand that the policy of achieving value for money appliesparticularly to the award stage of the procurement process. It is for the customer todecide what to buy and to set the specification, in the context of their overalloperational and policy objectives, including the Scottish Executive’s objectives onenvironmental matters, and subject to the normal public expenditure tests of need,affordability and cost-effectiveness. It is at this early specification stage that there ismost scope to consider environmental issues. There is a clear distinction – which isoften not understood - between what can legitimately be done at the specificationstage and what can legitimately be done at the award stage.Specification Stage

Public sector bodies may frame the contract specification in such a way as to ensurethat the work will be carried out in an environmentally sound way. For example acustomer can choose to specify and purchase low emission vehicles (even wherethey might be more expensive than standard vehicles). Value for money must beachieved, however, in the contract award process, i.e. the contract should beawarded to the bidder offering the best combination of whole-life cost and quality tomeet the requirement for low emission vehicles. And the requirement itself, for lowemission vehicles, must be tested for need, affordability and cost-effectiveness in thecontext of the customer’s overall objectives. However, this is a matter of prudentfinancial management generally rather than specifically one of procurement policy.

However, the specification must not be drawn up in a manner which frustrates thepurposes of competitive tendering by unfairly restricting the tendering process to asingle supplier or to a narrow group of suppliers or to suppliers from one country orlocality. In other words, materials should not be specified which are not widelyavailable and, in addition, prospective contractors should be allowed to substituteother materials which will still meet the customer’s environmental objectives in anequivalent manner.

Award Stage

All tender evaluation criteria used must be justified by the subject of the contract.The purpose of the award stage of the procurement process is to allow thecontracting authority to assess which tender best meets its needs. The evaluationcriteria chosen should help the authority to do this. They should relate to the intrinsicqualities of each of the bids when compared to the stated requirements of thecontract, and not to secondary issues, such as external costs or benefits. This iswhat is meant by criteria having a direct link to the subject of the contract. In suchcases it is essential, in order to meet the EC’s overarching principle of transparency(which applies to all procurements, whether they are above or below the ECthresholds) that it is made clear at the outset that the environmental characteristicsof the goods being procured will be part of the evaluation criteria. The award criteriamust be mentioned in the contract notice or contract documents. They should belisted in descending order of importance. It is good practice to also include therelative weighting given to each of the criteria. This is a requirement of the newconsolidated EC procurement Directive.

Further information on public procurement and sustainable development, andguidance for buyers is available at

http://www.scotland.gov.uk/about/FCSD/PCSD-POL/00017839/susdevguide.aspx

5. Decisions on Environmental Policy and Standards

Figure 2 illustrates the process whereby environmental costs could be included inwhole life costs. Essentially, this would be achieved by environmental regulators andother central government bodies ensuring that such costs were no longerexternalities by means of environmental taxes and regulations which made polluterspay the cost of environmental damage prevention or environmental restoration or an

amount reflecting the value placed by the regulator on the environmental losssuffered.

The purchasing body may choose to specify requirements which go beyond thoselaid down by legislation. In doing so, it must ensure that it complies with all relevantlaws and regulations (e.g. does not unfairly discriminate) and must be prepared tojustify any associated cost premia.

A public or private sector body making purchasing decisions may wish to have itsown environmental policy or guidelines. As a minimum, all public and private sectorbodies must comply with current legislation. However, an environmental policyshould go beyond this and detail any additional requirements that senior or topmanagement deem appropriate and this policy should be disseminated.

When an item of work is planned and the decision is taken, either voluntarily or incompliance with legislation, to invite outside tenders for the work, the buyer and theCustomer will draw up a general specification of the work to be done, ensuring thatthe nature of this work does not, of itself, breach the Executive’s own environmentalpolicy or regulatory standards. The purchasing department, in consultation withother managers, will then draw up a detailed specification which ensures that theobjectives set out in the outline specification are required to be met while at thesame time laying down any specific requirements necessitated by the environmentalpolicy.

It is then a matter for prospective suppliers competing for the work to ensure thatthey comply with all laws and regulations and while meeting the requirements of thepurchasing specifications and pay all environmental taxes resulting from theiractivities. The costs of compliance with regulations and the amount of environmentaltaxes will have an impact on the price which suppliers will need to charge for thework.

The purchasing department will make a decision on the basis of a number ofpreviously notified criteria, including the full cost to the purchasing body of each ofthe proposals. This cost will include both the price stated by the bidder and anyadditional costs which the purchasing body will have to bear. These additional costsmay include costs of environmental taxes and costs of compliance withenvironmental regulation which will fall on the purchasing body rather than thesupplier. Different proposals may involve different customer-side costs.

EnvironmentalPolicy

OutlinePurchasingSpecificationEnvironmental

Taxes

SeniorManagement/End User

EnvironmentalRegulations

Proposals andTender Prices

ContractAward

1. Figure 21.1 A Structure for Including Environmental Costs in the Consideration of Contract

DetailedSpecification

Ministerial Direction

1.1.1 Green

PurchasingDepartment

6. The Contract Specification

The contract specification is the key document in the procurement process. This isthe description of the goods or services, which is drawn up before tenders are invitedfor the work. A contract specification must state in all necessary detail the goods,services or works which are required, the dates on which they must be delivered or(in the case of services) the periods during which they must be delivered and thelocations at which they must be delivered.

A clear and adequate contract specification is essential for any life cycle costingexercise. Both the customer who will actually use the goods or services and,especially if the user department is a support service department, those departmentswhich will rely on the operations of the user department, should be involved in thedrafting of the contract specification. For example, in the case of a maintenancecontract for computers operated by a local authority’s central IT unit whose dutiesinclude providing housing benefit calculations to the finance department, the IT unitmust consider the possible effects of different patterns of scheduled downtime on theunit’s ability to carry out its work. The IT department must then inform the financedepartment of the effects of different downtime patterns on the authority’s ability toprocess new claims, amendments and cancellations within an acceptable timeframe. The finance department can then consider which downtime patterns areacceptable and this can be stated in the contract specification. The contract itselfshould also lay down remedies for excessive downtime.

The specification needs to focus on the outcomes which must be achieved by thecontractor. This will enable invitations to tender to focus on the provision of thegoods, services or works which the purchasing organisation actually needs.

There may, of course be more than one method of meeting the Executive’srequirements. In this case, some choice will have to be made about the method ofservice provision before the invitation to tender is drawn up. For example, there maybe a requirement for office accommodation which could be met by leasingaccommodation, buying and refurbishing existing offices or having new offices built.The decision will have to be taken on whether or not paying for the construction ofnew offices is likely to provide better value for money than buying or leasing existingaccommodation before tenders are invited for construction work.

7. Using Discounted Cash Flows in Costing

One final point must be made about whole life costing. Because it deals withpayments and receipts over a long period of time, it is necessary to makeadjustments for the time value of money. Payments to be made in the near futureare held to have a higher Net Present Value than payments to be made in the distantfuture when calculating whole life costs of projects because they affect the amount ofresources available in the short term. It is often more useful to have resourcesavailable in the short term than in the long term because of the knock-on effects ofshort-term expenditure on the future. Cash inflows and outflows are adjusted to theirNet Present Value by multiplying them by a Net Present Value factor which is lowerthe further in the future the cash flows will be. The use of discounted cash flows isexplained further in the Annex A.

Summary

♦ Whole Life Costing aims to determine the full cost of a solution to a requirementover the full period that the requirement will exist.

♦ Whole Life Costing can be applied to leased assets as well as to owned assetsand can be used to compare the cost of leasing and outright purchase.

♦ Whole Life Costing should be seen as a means of costing different methods ofachieving an objective. This means that a project specification should be drawnup which clearly identifies what objective is to be achieved before a decision istaken on how to achieve it.

♦ Whole Life Costing should form only one element in purchasing decisions, whichshould also reflect quality considerations and may reflect environmental andsocial consequences which do not give rise to costs to the purchasingorganization. However, considerations of quality and of environmental and socialconsequences must not be allowed to give rise to anti-competitive purchasingprocedures. In taking these factors into consideration, public sectororganisations must also act within a clear policy framework and comply with thelaw and regulations.

Annex A - Using Discounted Cash Flows in Costing

A complication which arises in calculating the whole life cost of an option is the timevalue of money. Essentially, it is more advantageous to receive money earlier ratherthan later and to pay money later rather than earlier. This is because the cash whichhas been received can be spent on other projects which help to achieve theorganization’s aims or alternatively invested to earn interest or used to pay off debts,thereby reducing interest expenditure. In the same way, cash which does not haveto be used to make a payment can be used for other purposes.

This is illustrated by the following example:

A manufacturing company presently makes a profit of £2 million per annum. Thecompany has decided to build a new factory, costing £10 million to assemble ‘whitegoods’. The company has an offer of a loan of £10 million to enable them to buildthe factory now (Option A). Alternatively, they could wait five years and use theprofits generated in the intervening period to build the factory (Option B). Theyexpect to make a profit of £2 million per year from the products made in the factory.When the factory has been in operation for twenty years, it will be replaced by anewer, larger and better factory paid for out of the earnings it has generated. If thecompany take out the loan, they will be required to pay it back in five years’ time. Inthe meantime, they will pay interest of £1 million per annum.

Whichever option is chosen, the company will have to make a one-off payment of£10 million in five years’ time, either to build the factory (Option B) or to pay off theloan (Option A). However, if the company borrows the money and builds the factorynow (Option A), they make £1 million more profit every year (after interest) for thenext five years. They will also be able to build the next factory and thereby increasetheir profits further, five years earlier than they would be able to do if they waited topay for the factory out of profits (Option B).

This means that at any given moment in the future, the company will have generatedmore money if they chose Option A, giving them the money now, than if they chooseOption B, giving them the money in five years’ time.

Moreover, if the company had sufficient money right now without having to borrow it,then their future profits would be even higher, because there would be no interestexpense.

In other words, there are advantages to having money now rather than in five years’time. In the public sector, the benefits of having more money now are likely to be interms of providing better services, treating more patients or making more savingsearlier, rather than in terms of income generation but the principle will still be thesame. At any given time in the future, you are likely to have achieved more if youhave the same amount of money now instead of in five years’ time.

The extent to which it is desirable to have the money now is determined by theextent of income generated, costs saved or benefits obtained, compared with theinterest cost. If, in the above example, the factory was only expected to generate

£500,000 per annum the interest cost under Option A -– the cost of using the moneyor cost of capital - would have outweighed the gains from building the factory earlier.

In order to take account of the cost of capital in making decisions about spendingmoney, a notional interest rate, known as the discount rate, is used. The net cashinflows (such as the profits from the factory) or outflows (for example the loanrepayment) for each year are multiplied by a Net Present Value (NPV) factor to givethe Net Present Value of the cash flows. Each year’s NPV factor is calculated bydividing the previous year’s NPV factor by one plus the discount rate expressed as apercentage. For example, if the discount rate is 6%, the NPV factor for the first year(usually called Year 0 in NPV calculations) will be 1, the NPV factor for the next year(Year 1) will be (1 ÷ 1.06) = 0.9434, the NPV factor for Year 2 will be (0.9434 ÷ 1.06)= 0.8900, the NPV factor for Year 3 will be (0.8900 ÷ 1.06) = 0.8396 and so on.

The use of discounted cash flows is a necessary adjustment to whole life costing.However, the general principle of whole life costing, namely that every significantcost of every option must be assessed in deciding which option is the cheapest, isfar more important.