I have been interested in energy efficiency for a while, and I have been interested in designing cost effective buildings for a while. On the energy efficiency side, my efforts to develop as a designer has led to using quantitative analysis in design: energy modeling programs like Therm, eQuest, and the Revit/Green Building Studio package. These tools allow one to be fairly authoritative when comparing one design scheme to another.
simple payback does not take into account the time value of money. LCCA does.
On the cost effectiveness side, the easy analysis is simple payback. When comparing an alternative to a base case, what is the difference in first cost, and what is the annual savings between the alternative and the base case? If an alternative first cost is $100 more than the base case, and the alternative saves $10 per year, then after 10 years the alternative breaks even with the base case.
Many projects face a go-no go decision. Do we upgrade lights in the classrooms, or not? If we do not, we know we will be spending $100 per year in electricity cost. If we do, we are faced with the capital cost of installing the lighting, hopefully offset by energy savings.
Institutional clients are in a good position with analyze capital projects using a life cycle perspective, because they plan on being around for the foreseeable future. We frequently work with schools. Some may close, but many can count on being in their facility decades from now. Thus, life cycle cost decisions that deal in the 20-30 year range are very appropriate.
Well-known differences between simple payback and life cycle cost analysis (LCCA) is that simple payback does not take into account the time value of money, and it is interested in a future break-even date. LCCA takes into account the time value of money, and its period is the life of the project or component. The drawback with LCCA is that the formula is a bit more complicated. You either know how to work the formula, or you do not.
As it turns out, the LCCA formula is not terribly complicated. And it turns out, the federal government is the entity most interested in LCCA. The National Institute of Science and Technology has apparently written the book on LCCA. NIST Handbook 135 is the definitive guide to LCCA.
A dollar spent today is worth more (today) than a dollar that will be spent in the future. Getting paid today is better than getting paid the same amount tomorrow. The corollary is that money spent today is expected to have a return. If we invest $100 today, we expect to receive $101 when we collect tomorrow. So, if we are faced with a decision whether to invest in a capital project, we need to ask if we are better off investing in the stock market, or the project. Money wants a return, regardless the investment type.
Another issue facing decisions on capital projects is a bit more qualitative. If lighting in a classroom is bad, what are the benefits, outside the economic ones, that accrue with a lighting project? Educational classrooms exist to deliver educational outcomes. Can we increase educational outcomes through better lighting? What are we willing to pay for increased educational outcomes? When a school board member is asked this question, they may reply that a 1 percent increase in educational outcome is worth $100. Therefore a lighting improvement project is worthwhile if, for $100, we can increase educational outcomes by 1%.
What is the LCCA formula? It is this:
LCCA = Investment Costs + Replacement Costs – Residual Value + Energy Costs +OM&R Costs,
where OM&R is operations, maintenance and repair. Each of the future costs is discounted to present, or constant dollar, costs. The discounting of future costs is done using a discount rate: the multiplier that turns future costs or savings into present value costs or savings. Thus, $100 saved in ten years might be worth $80 today. LCCA uses the $80 figure to compute the value of saving $100 in ten years.
The big question, of course, is how do you discount future costs and savings? The answer is the federal government provides discount rates for federal projects, and this discount rate can be used to analyze private sector projects. Along with NIST Handbook 135 is a NIST annual supplement of energy price indices and discount factors. These provide discount rates that can be plugged into LCCA equations to turn future costs into present value costs. I have my own LCCA spreadsheet that uses a cash flow diagram to let me visually see how money is spent over a study period.
What is the bottom line? Many projects that are of questionable value using simple payback analysis are firmly valuable using LCCA. This is good news for those interested in doing capital projects. In the long run, many capital projects make sense. They make sense not because the simple payback is there, but because money has a value that depends on time. When one takes into consideration the time value of money, a dollar spent today is oftentimes a dollar well spent.