When you run a small business, every little cost counts. Making poor purchasing decisions can put an unnecessary financial burden on your business and lower your company’s bottom line over time. Before you purchase new assets for your business, practice life cycle costing.
Knowing the life cycle cost, or whole-life cost, of an asset impacts business budgeting, product pricing, and decision making.
What is life cycle costing?
Life cycle costing, or whole-life costing, is the process of estimating how much money you will spend on an asset over the course of its useful life. Whole-life costing covers an asset’s costs from the time you purchase it to the time you get rid of it.
Buying an asset is a cost commitment that extends beyond its price tag. For example, think of a car. The car’s price tag is only part of the car’s overall life cycle cost. You also need to consider expenses for car insurance, interest, gas, oil changes, and any other necessary maintenance to keep the car running. Not planning for these additional costs can set you back.
The cost to buy, use, and maintain a business asset adds up. Whether you’re purchasing a car, a copier, a computer, or inventory, you should consider and budget for the asset’s future costs.
Life cycle costing process
Conducting a life cycle cost assessment helps you better predict how much your business will pay when you acquire a new asset.
To calculate an asset’s life cycle cost, estimate the following expenses:
- Purchase
- Installation
- Operating
- Maintenance
- Financing (e.g., interest)
- Depreciation
- Disposal
Add up the expenses for each stage of the life cycle to find your total.
You might use past data to help you create a more accurate cost prediction. To simplify the process, start with your fixed costs. Fixed costs for businesses are the expenses that stay the same from month to month. Then, estimate variable costs, which are expenses that change.
Life cycle costing process for intangible assets
You can also use life cycle costing to determine how much your intangible assets will cost. Intangible assets are non-physical property, such as patents, your business’s brand, and your reputation.
Although it is more difficult to add up the whole-life cost of an intangible asset than a tangible asset (physical property), it’s still possible. Consider the total cost of acquiring and maintaining an intangible asset.
For example, patents cost thousands of dollars. You might also need to hire a lawyer to help you obtain one. And, you will need to pay fees to maintain your patent.
Or, consider your business’s brand. You might spend money on all the things that go into creating your brand, such as developing a logo, registering your name, and setting up a small business website. Further, you will spend money on marketing and maintaining your brand.
Life cycle costing assessment example
Let’s say you want to buy a new copier for your business.
Purchase: The purchase price is $2,500.
Installation: You spend an additional $75 for setup and delivery.
Operating: You need to buy ink cartridges and paper for it, so you estimate you will spend $1,000 on these supplies over the course of its useful life. And, you expect the total electricity the copier will use to be $300.
Maintenance: If the copier breaks, you estimate repairs will total $450.
Financing: You purchase the copier with your store credit card, which has an interest rate of 3.5% per month. You pay off the printer the next month, meaning you owe $87.50 in interest ($2,500 X 3.5%).
Depreciation: You predict the copier will lose value by $150 each year.
Disposal: You estimate it will cost $100 to hire an independent contractor to remove the copier from your business.
Although the purchase price of the copier is $2,500, the life cycle cost of the copier could end up costing your business over $4,500.
Purpose of the life cycle cost analysis
As mentioned, conducting a life cycle cost analysis helps you estimate how much an asset will cost you over the course of its life.
Take a look at some of the reasons why knowing an asset’s total cost can guide your business decisions.
1. Choose between two or more assets
Using life cycle costing helps you make purchasing decisions. If you only factor in the initial cost of an asset, you could end up spending more in the long run. For example, buying a used asset might have a lower price tag, but it could cost you more in repairs and utility bills than a newer model.
Life cycle cost management depends on your ability to make a smart investment. When you are deciding between two or more assets, consider their overall costs, not just the price tag in front of you.
2. Determine the asset’s benefits
How do you know if you should buy an asset? Generally, you weigh the pros and cons of your purchase. But if you only consider the initial, short-term cost, you won’t know if the asset will benefit your business financially in the long run.
By using life cycle costing, you can more accurately predict if the asset’s return on investment (ROI) is worth the expense. If you only look at the asset’s current purchase cost and don’t factor in future costs, you will overestimate the ROI.
3. Create accurate budgets
When you know how much an asset’s total price is, you can create budgets that represent your business’s actual expenses. That way, you won’t underestimate your business’s costs.
A budget is made up of expenses, revenue, and profits. If you underestimate an asset’s cost on your budget, you are overestimating your profits. Failing to account for expenses can result in overspending and negative cash flow.
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This is not intended as legal advice; for more information, please click here.