Includes Life Cycle Cost Analysis, Cost-Benefit Analysis and other tools that impact an ROI
Many facility management professionals view financial planning merely as an exercise in preparing the annual operating budget and nothing more. However, the term financial planning has more to do with predicting the return on an investment and preparing an investment strategy than with allocating the existing budget to existing needs.
In general, facilities financial performance means how well a facility performs as a financial asset. Measuring this performance will hinge on the approach you take to financial planning. Your approach well help you establish a set of assumptions about what constitutes good financial performance; these assumptions must relate to the facilities function as well as to the financial structure of your company. Even slight changes to these assumptions can create large differences in overall performance and how it is measured.
The approaches described below are not always mutually exclusive and can often be used in conjunction with each other. Planning any major facilities proposal should include an analysis of each method to see how it performs from each perspective.
Lowest First Cost Analysis
While other approaches to financial planning are based on the criterion of time, the lowest first cost approach entails finding the lowest-priced item that meets your specifications at the time you need it. This approach works best for a narrow set of circumstances.
- Many vendors supply the commodity you need and most brands are identical in all major respects, such as size and quantity of pieces per package (for example, white latex paint).
- Many vendors compete in a fairly stable market to ensure a steady source of supply.
- Substitution of one brand for another can be made easily (for example, several brands of paper towels fit in the same model of dispenser).
- An item can be precisely specified.
- The economic life cycle of the desired item is short or nonexistent. If an item needs to last no more than two years but is built to last for 10 or 15 years, that extra durability may not be of any value for its probable higher cost.
- There are no maintenance or operating costs associated with the item.
Common sense tells you when the lowest first cost strategy is the best choice. However, it is not sufficient for all planning needs. Virtually any activity involving the provision of human services involves quality issues that are almost impossible to quantify into an ironclad specification. If quality matters, the lowest first cost approach cannot be relied on to provide satisfactory results. Therefore, the specifications for such a facility must be well defined and accepted to maintain a certain minimum standard of performance.
Yet, in a slow economy this approach becomes very appealing. If operating cash is scarce, corporate executives may consider this the only viable approach. However, it almost always results in higher long-term operating costs and higher total life cycle costs. For example, buying the cheapest paint may justify lowest first cost from an accounting standpoint, but buying higher-priced, more durable paint that will lower future maintenance and housekeeping costs may make more sense functionally. These considerations are part of life cycle cost analysis, which is discussed below.
Life Cycle Cost Analysis
Life cycle cost analysis (LCC) is a construction-based decision method, not an accounting method. There are three major cost categories in a life cycle cost analysis.
- Initial costs of acquisition of the asset — such as purchase, design, delivery, installation, testing, reconstruction, and moving
- Ongoing expenses — such as utility, servicing, and maintenance costs — that continue throughout the life of system operation
- One-time future expenses — such as system calibration after commencing operation, and major upgrades or overhauls — that occur infrequently and predictably during the life of the asset
Life cycle cost analysis should account for all costs and returns associated with an item over its entire (economic) life cycle, including cost of removal and any salvage value obtained when the asset is disposed of. It should also address associated personnel, energy, maintenance, replacement, and other costs affected by the investment.
In addition to total costs, the life cycle cost approach considers the effect of time. It considers the effects of inflation and the cost of any funding borrowed to acquire the asset if the ROI (return on investment) is to be predicted accurately. (Methods of calculating the time value of money are described below and explained in further detail in the BOMI International course Real Estate Investment and Finance.) This approach works best when you compare the total lifetime costs of several options for solving a problem. Therefore, this approach is valid for analyzing investments when long-term payback is a major factor. The shorter the asset life, the less useful this method becomes.
When calculating life cycle costs, many factors are considered:
- determine the life expectancy of any product or project
- assess all costs and discounts, plus tax ramifications
- identify costs that are capitalized and those that are expensed
- estimate the inflation rate that will occur during the life of the project
- estimate the real interest rate during the life of the project
Because assumptions may vary widely, the best approach is to predict outcomes based on a range, such as an inflation rate of a minimum of 3 percent and a maximum of 8 percent annually.
Installing complex or compound assets such as energy management systems can best be justified by using life cycle costing. The cost of an energy management system is added to standard electrical and mechanical equipment costs. To justify the additional cost, quantify the savings that are produced in associated areas. Energy management systems and other such products produce cost avoidance or cost savings after the payback period (explained below).
Life cycle costing is also useful for producing documented information about longer-term savings. Most products require some amount of maintenance to operate effectively over the long term. Therefore, such costs must be considered when making a final product decision.
Cost-benefit analysis asks: “Are the benefits of a project worth its costs?” Cost-benefit analysis should be the method of choice if you must compare quantifiable (measurable) with qualitative factors. It is not difficult to see that decisions made on the basis of quantifiable costs or savings (avoided costs) are easier. This method is useful when analyzing projects that involve physical improvements to tenant space but do not affect the market or asset value of the property as a whole. It can even be used to support trade-offs between cost related and qualitative factors. It should not be confused with life cycle cost analysis, in which costs are assessed over an investments useful life, but not against its benefits.
Not every quantifiable issue relates to cost. For example, specifications for computer systems include many measurable elements that do not relate directly to cost, such as amount of RAM, megabytes of disk space, and the clock speed of a chip, as well as software features, such as the inclusion of automatic spell checking or advanced graphing capability.
To conduct a numerical comparison of hard and soft costs, you will need to apply relative-weighted numeric values to qualitative factors and to costs. These numbers can be manipulated to derive an overall score that indicates how well a given project or proposal fulfills the department or companys stated objectives.
When you begin any cost-benefit analysis, consider the following issues:
- Specifically, what is the project intended to accomplish?
- What conditions constrain or affect the project?
- What conditions might exist after the project is completed?
- Which conditions are controllable and which are not?
- What performance requirements or time and cost criteria will be used to evaluate effective project performance?
- What is the minimum acceptable level of performance in each category?
Hard Costs and Soft Costs
Hard costs are those associated directly with actual construction, leasing, maintenance, and upkeep. Hard benefits are savings on revenues generated directly from these activities. Soft costs and benefits are those related to the management of construction, leasing, and maintenance and upkeep, such as overhead, fees, and management time. These distinctions are not accounting or budgetary conventions, but may figure prominently in the thinking of executives who may be reviewing the project. As you plan for facilities projects, keep in mind that the argument for some costs is more persuasive than for others.
- Most persuasive are hard costs or benefits that can be measured and attributed directly to a specific activity, account, or client and charged and reimbursed (for example, tenant improvement construction costs or savings for a specific space or lease), especially if charged against gross sales to reduce tax liability.
- Also persuasive are hard costs or benefits that can be measured and are billable but are not attributed directly to a specific project or customer and therefore are allocated on a prorated basis and reimbursed (for example, overhead costs).
- Less persuasive are tangible but unmeasurable soft costs or savings (for example, projected savings in staff time that cannot be tracked or verified in a practical way).
- Least persuasive are intangible and unmeasurable soft costs or savings (for example, improved quality of service) because evaluations are often subjective or inconsistent.
It is more difficult to compare hard (quantitative) costs/savings to soft (qualitative) costs/savings than to compare hard costs and savings to each other. The less measurable something is and the more one mixes bases for evaluation (cost vs. time vs. quality, for example), the more difficult comparison becomes. Consequently, project justifications often present the strongest possible case in cost numbers first and treat other justifications as secondary arguments. The evaluation process is often structured into three levels:
- Quantitative vs. quantitative factors
- Quantitative vs. qualitative factors
- Qualitative vs. qualitative factors
The emphasis placed on the importance of hard or soft costs/savings depends on the attitude of senior management. All cost analysis studies must be conservative. Even so, many managers, while acknowledging that some projects do have soft costs and savings associated with them, will discount them entirely because they are not as concrete as hard costs or savings.
Facility managers must understand many important financial concepts in order to communicate effectively with corporate executives. Along with a thorough understanding of the core business, these financial concepts are vital if facility managers are to speak the language of business and gain the confidence of corporate executives as genuine contributors to corporate profitability and well-being.
This article is adapted from the BOMI International course Fundamentals of Facilities Management. More information regarding this course is available by calling 1-800-235-2664. Visit BOMI International’s Web site.