Lecture 8 - Comparative Cost Planning PDF

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Construction Economics. Lecture 8 - Comparative Cost planning. Achieved a 1st in the module. Lecturer Dr Martin Tuli...

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Comparative Cost Planning Definitions 

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Life cycle cost o The cost of an asset, its parts throughout its cycle life, while fulfilling the performance requirements Life cycle costing o Methodology for systematic economic evaluation of life-cycle costs over a period o Period of analysis could be the entire life cycle or selected stages or periods of interest Whole life cost o All significant and relevant initial and future costs and benefits of an asset, throughout its life cycle, while fulfilling the performance requirements Whole life costing o Systematic economic consideration of all whole-life costs and benefits over a period of analysis

Drivers for WLC/ LCC 

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Focus on reducing costs of constructing operating, maintaining and disposing of constructed assets o Local authorities o Private clients (& contractors) – Understand full cost of ownership o PFI consortia – Contractors want to know how much it will cost them o Funders and insurers o IUK Concerns with sustainability

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Whole life costs are 5-10 times as much as the capital or initial costs. And so WLC matters

Associated costs in LCC   

Initial costs Recurring costs for occupational charges Recurring costs for refurbishment and redevelopment – Included in the developers budget

Building life 

Useful life of building is generally considered as the lesser of its o Physical life o Functional life o Economic life

Building life – physical life  

Relates to physical deterioration with use and the passage of time Depends on o Design o Detailing and construction methods o Building use o Repair and maintenance policies and practice

Building life – functional life   

Relates to obsolescence Obsolescence is defined as decline in value not caused by the use or passage of time Functional obsolescence relates to change in functional standards or use

Building life – Economic life  

Relate to obsolescence Economic obsolescence relates to efficiency or the highest/ best use of the land and property on it

Component life 

Component lifespans can vary widely o Physical deterioration is less of a determinant o Functional, economic and other types of obsolescence are more significant o Yet available scientific data is mostly based on component longevity, not obsolescence

Life cycle cost plan 

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Comprises the capital cost and present values of the following costs o Maintenance o Redecoration o Minor new work o Energy o Cleaning o Additional tax allowances IN practice, LCC is usually used for the evaluation of alternative design solutions for a specific building (or its elements) A lot will change in a building overtime Therefore knowing the cost today may not be that useful

Limited adoption of WLC/ LCC    

Not widely used Capital and operational budgeting practices Promoters interest in getting scheme funded Lack of or unreliable data

Discount Rate 

Rate reflecting the time value of money. Money will be worth less in the future because of inflation o The rate applied should be the opportunity cost of capital o However, in practice, it is the cost of capital (interest rate) o This is called the nominal discount rate

Discount Rate   

The rate used may be adjusted for inflation – This is called the real discount rate Where d is the interest rate and I, the rate of inflation For simplicity, discount rate r= d-i

Discount rate 

Uses o o

To convert future values to present values (i.e. discounting) To convert present values to future values (I.e. compounding)

Present value 

Monies accruing in the future which have been discounted to account for the fact that they are worth less at the time of calculation o PV of a lump sum to be paid in the future (PV of £1) o Where, r is the discount rate and n is the number of years

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PV of regular annual payments for a number of years (PV of £1 per annum or PV of an annuity) Where, r is the discount rate and n is the number of years

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NET present value (NPV) 

This the sum of the discounted future cash flows o The net present cost (NPC), where only costs are included o It is the standard criterion for deciding whether an alternative can be justified on economic principles

Annual equivalent (AE) 

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The AE value is the regular annual cost that, when discounted equals the NPV of the investment o AE of a lump sum to be paid now (AE of £1) = NPV/ PV of annuity o Where, r is the discount rate and n is the number of years Used to compare the merits of competing investments where the natural replacement cycle is not an exact multiple of the period of analysis The alternative with the lowest AE cost, will also have the lowest total cost

Net Savings  

Expressed in PV and in the unit of currency PV of operating-related savings minus the PV of additional investment costs o When assessing the viability of alternatives, this is the difference between the LCC of two alternatives o When comparing investment alternatives, the alternative with the highest net savings or lowest LCC is preferred

Payback period

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Calculated as the number of elapsed years between the initial investment, its subsequent operating costs and the time at which cumulative savings offset the investment o Simple payback: uses real (non-discounted) values of future cash o Discounted payback: Uses PVs of future cash flows o When assessing the viability of alternatives, the payback period is the time it takes to recover the initial investment of one alternatives relative to another o When comparing investments with future expenditures, discounted payback is used to reflect the time value of money

Savings-to-investments ratio (SIR)  

Expressed in PVs and is a dimensionless measure Calculated as the ratio of future (net) savings to investment costs o When assessing the viability of alternatives, a ratio greater than one implies the alternative is cost effective o When assessing investment alternatives, priority is given to the alternative with the highest SIR

(Adjusted) internal rate of return (A/IRR) 

The compound rate of interest that, when used to discount cash flows over the period of analysis, makes costs equal to benefits when cash flows are reinvested at specified interest rate o When assessing the viability of alternatives, the IRR is the discount rate that makes the LCC of two alternatives equal to one another o When assessing investment alternatives, the AIRR is the discounted rate that sets the NPV to zero

Treatment of uncertainty 

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Characterising uncertainty o Ideally, provide probability distributions of potential cash flows (I.e. benefits, costs and net benefits) Sensitivity Analysis o Analyses should show the sensitivity of the NPV and other outcomes to variations in major assumptions o Should at least be considered for estimates of cash flows, the discount rate, the general inflation rate and distributional assumptions

Sensitivity Analysis – Example 

Costs at different discount rates

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Costs increased/ decreased by 10%

Optimistic and pessimistic estimated services lives...