Life cycle cost models

There are several financial methods for assessing value for money or making an investment decision, the most common of which are:

• Net present value
• Future cash
• Current cash

Net present values

These calculations assume that cash invested now will be worth more in the future. Costs therefore decrease each year to take into account investment earnings. It is the equivalent of setting up a sinking fund to fund future planned maintenance and replacement.

For government decision making to justify an action, discounted cash flows to provide net present values are recommended. This economic measure enables direct comparison of different future cash flows (expenditure and income) to be assessed at present values.

The life cycle cost is the sum of capital costs and discounted future costs or incomes for a given period.

To allow comparison between different size buildings and time periods, life cycle costs are often expressed in units of £/unit/year for a given period and discount rate. Units are usually expressed in m² of building area but may alternatively be functional units, such as bed spaces for a hotel, or number of pupils for a school.

Using net present values means that the further in the future a cost occurs, or the higher the discount rate, the less the impact on the life cycle cost. A zero discount rate is the equivalent of current prices or values.

Future cash

Future cash calculations ignore investment earnings and costs are increased each year to take into account the effects of inflation. This method assumes that all maintenance costs increase with time, and can be used to show that higher investment now can lead to lower future costs.

Current cash

In current cash calculations, all costs remain at present day values. No adjustments are made for either inflation or for investment earnings.

Discount rates and inflation rates

An appropriate rate must be selected when applying an adjustment rate to calculated current costs.

The presently recommended government discount rate is 3.5% for periods up to 30 years, though this rate should be reduced for longer term projects. Full guidance on discount rates can be found in the government’s Green Book. Discount rates in the commercial sector tend to be higher (6% or more) and are based on inflation, interest rates, investment income and risk.

For inflation rates to be used in future cash calculations the government’s National Statistics department published monthly rates of inflation as both the retail prices index and the consumer prices index.