Present Value Cost Analysis
7 August 2009
Topics: financial analysis, present value, cost
analysis, decision making
This article discusses a simple, yet powerful method to make difficult engineering or business decisions.
Business Abounds with Complex Decisions
Many business decisions involve evaluating the cost of providing or acquiring a service. An abundance of alternatives and complex choices can make decisions difficult. Differing capital, operating cost, maintenance cost, salvage value, and performance can complicate your analysis.
Even if you come to a conclusion, communicating your decision can be hard.
Present Value Cost (PVC) Analysis
I have consistently used a technique that addresses these challenges. The method, called Present Value Cost Analysis, can handle complex, multi-cost alternatives. This technique can accommodate the many types of costs—for instance: single event costs—such as capital and salvage—and recurring costs—such as operating and maintenance expenses.
Present Value Cost Analysis is a method that aggregates capital and operating costs all to the same point in time. This technique promotes a fair comparison of alternatives.
Several years ago I applied this approach to a difficult evaluation at a process plant. A team of engineers and managers were attempting to compare a large number of alternatives to provide product filtration. The facility operated a variety of vacuum and pressure filters. We were evaluating new equipment to reduce costs and improve operating efficiency.
Before the assessment was complete, we looked at more than a dozen filters. Even after screening out inappropriate equipment, there still remained seven viable alternatives. Each type of filter possessed a different performance, different initial capital, different installation cost, different operating cost, and different maintenance cost. Needless to say, the volume and complexity of the information greatly complicated the decision making.
What finally proved an effective means for comparing the alternatives was the Present Value Cost method. For each option, I developed a PVC. I did this by impartially estimating the following cost components:
- Initial capital
- Installation
- Operating cost
- Maintenance cost
- Performance (i.e., unit productivity)
I arranged these costs for each alternative on a timeline and discounted them back to the present using the company’s cost of capital. This provided a single Present Value Cost for each alternative. I presented the values in a bar chart. With this, middle and senior management quickly grasped the relative benefits of each alternative, and we were able to justify a large capital appropriation to implement an important plant betterment project.
Another name for PVC is life cycle cost. The term implies the full cost for owning and operating a piece of equipment for the equipment's full life. The life cycle cost can be expressed as a present value or as an annual value. It also can be converted to a unit rate tied to performance (such as $/pound, $/ton, $/gallon, £/kilogram, €/liter, etc.).
Conclusion
In summary, the Present Value Cost is the sum of many different types of costs discounted to the present. The PVC also can be called the life-cycle cost.
To its credit, PVC analysis can:
- Facilitate comparing complex alternatives
- Account for the time value of money
- Consolidate many different types of costs into one value
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