Procurement with a Life Cycle Cost

It has been more than two years since Prozorro introduced Life Cycle Costing (LCC) procurement. So far, however, this tool has not been very effective.

If you filter all procurement with the use of the LCC method, you will see just over a hundred tenders. In most of them, the procuring entity specified this method in error, that is, no life cycle costing is mentioned in the tender documentation. For example, in 2022, procuring entities selected the LCC criterion in 63 tenders — by mistake in every single one of them.

On the other hand, LCC has been used successfully worldwide for many years. Why is it not catching on in Ukraine?

There are several reasons. First, LCC procurement is much more complex than regular procurement and takes more effort. Secondly, procuring entities don’t always understand how and when this criterion should be applied.

Let’s try to understand the main principles and pitfalls of this procurement type.

WHAT IS A LIFE CYCLE?

First, it’s important to understand the fundamental difference between the concepts of “warranty period,” “statutory service life,” and “full period of product operation (use).”

The warranty period provides for a certain period during which the malfunction of the product (part of the product) is not acceptable. It obliges the manufacturer / supplier to fix such faults should they occur.

The statutory service life is a certain period during which the manufacturer promises reliable operation of the product subject to the conditions of use of this product (regulatory of replacing consumables, maintenance, etc.).

But the product does not necessarily stop being used immediately after the statutory service life expires. The owner of the product can decide whether to replace it or to make more repairs and continue using it.

The procuring entity is not prohibited from determining the duration of a life cycle independently, but it is usually estimated at the level of the effective use period.

So, in order to clearly identify the life cycle, two main conditions must be met:

1. an effective period of use (service life) must be determined for the product;
2. all work or services required during this period must be clearly defined to identify the costs incurred during the life cycle.

If consumption of resources should be taken into account as well (e.g., resources such as fuel or power), statutory consumption per work unit must also be determined.

For example, if a vehicle consumes 6 liters of fuel per 100 kilometers, and the statutory service life (mileage) is about 250,000 km, we can calculate the consumption of fuel over this period.

WHY USE LCC PROCUREMENT

The main purpose of procurement with life cycle cost is to provide the procuring entity with an opportunity to compare goods with different costs in the process of use. Cheaper products can often entail significantly higher costs in the future. Therefore, focusing on the price alone is not entirely correct.

A trivial example is printers. A laser printer can be several times as expensive as an ink jet printer of the same manufacturer. But considering the costs of consumables (cartridges), the life cycle cost of a laser printer may be much lower.

Here are two popular models of the Canon printer:

Indicator	Canon ink jet printer	Canon laser printer
Price	UAH 3,600.00	UAH 12,500.00
Service life	5,000 sheets	10,000 sheets
Cartridge price	UAH 700.00	UAH 700.00
Page yield	400 sheets	2,400 sheets
The cost of printing 1,000 sheets	UAH 2,470.00	UAH 1,540.00

Therefore, what appears cheaper is not always really cheap.

WHY IT IS NOT NECESSARY TO INCLUDE ALL LIFE CYCLE COSTS

Procuring entities tend to approach the definition of life cycle criteria rather formally and enter all possible parameters into the calculation. But the important part is comparing the very parameters that will differ for a specific type of product.

For example, the cost of decommissioning should not be included if you are uncertain whether you are really going to replace the product following the end of its service life.

For some goods, the main comparison criterion is resource consumption. For others, on the other hand, this indicator will be almost identical, but the cost for maintenance and replacement of consumables will be different. Sometimes, some of the life cycle parameters do not objectively depend on the product type or cannot be identified in advance at all.

Therefore, the right way to go about it is to analyze what goods are available on the market and how life cycle components affect the total cost of those goods over time.

Key life cycle components to analyze:

1. Volume/cost of resource consumption per unit of work. This indicator can be taken into account only if the service life of the product is calculated based on a performance indicator (for example, mileage in km, hours of operation, etc.), and if this parameter is measurable.
2. The cost of replacing consumables during the life cycle.
3. Maintenance and other scheduled repairs provided by the manufacturer.
4. Other work related to the operation of the product. This may include additional equipment or modernization of available space.
5. Costs connected with the termination of the product operation (decommissioning, disposal).

In the case of printers, the procuring entity can only calculate the cost of consumables (cartridges) quite reliably. Other life cycle components are either absent or impossible to calculate in advance. Therefore, it probably makes little sense to include the cost of disposal and the consumption of resources (such as electricity) into the LCC calculation.

WHY ARE LCC TENDERS USUALLY USED FOR LARGE-SCALE PROCUREMENT

LCC procurement is quite a difficult procedure which requires the procuring entity:

• to study the market in detail;
• to understand the differences in the use of different types of goods;
• to come up with a method for calculating a life cycle unit;
• to develop a sufficiently high-quality and complex contract.

This means that such procurement requires a lot of time and effort. This is why this type of procurement is mainly used for costly or regular procurement. Only in that case will the efforts of buyers yield maximum savings by means of using a more complex procedure.

When preparing a tender with LCC, a procuring entity has to consult the market pre-tender to avoid errors and inaccuracies in the life cycle phrasings in the documents.

In global practice, such purchases are quite popular during tenders for the supply of specialized equipment, railway locomotives, trams and trolleybuses, energy facilities, and expensive production equipment. These are precisely the cases when the price of the life cycle of the product can significantly exceed its initial value on the market. Taking into account all future costs, the procuring entity can save millions of dollars.

ADJUSTED LIFE CYCLE COST

Often, products not only entail different costs during the life cycle, but also different effective use periods. In this case, the law allows to use an adjusted life cycle cost.

The relevant provision of Article 22 of the Law “On Public Procurement” goes as follows: “The life cycle cost can be calculated as the sum of all life cycle costs or the sum of all life cycle costs divided by the calculation unit of operation of the procurement item.”

How it works:

Indicator	Product 1	Product 2
Product price	UAH 1,000.00	UAH 1,500.00
Expenses during the life cycle period	UAH 1,700.00	UAH 2,300.00
Life cycle duration	2 years	3 years

If Product 1 is purchased, the procuring entity will have to replace it earlier and spend money again. To account for this difference, the average cost for an adjusted unit of use time should be determined. This unit is the value by which the life cycle duration of all products is divided. In this case, it’s 1 year.

Then the adjusted value is calculated as the sum of all expenses divided by the life cycle duration times the adjusted unit:

Adjusted LC cost = (Product price + expenses over the life cycle) / life cycle duration × adjusted unit.

For Product 1, the adjusted LC cost will therefore be:

(1,000.00 + 1,700.00) / 2 years × 1 year = UAH 1,350.00.

For Product 2:

(1,500.00 + 2,300.00) / 3 years × 1 year = UAH 1,266.67.

Without the use of the adjusted life cycle unit, the procuring entity would have to pick Product 1. But in fact, Product 2 offers better value for money. Therefore, before announcing a tender, you should make sure that the service life of all goods is identical, and if it’s not, the best idea would be to use the adjusted LC unit.

RISKS

The duration of the contract cannot be shorter than the duration of the life cycle. This means that the tender should include additional requirements for the participant to avoid having the supplier sell the product and just disappear.

In particular, contractual security should be taken care of. There can also be requirements for the company’s financial turnover and the experience in the market to protect the buyer against short-lived and unreliable companies.

The contract must oblige the supplier to fulfill the requirements during the product’s life cycle and include the procedure for transferring such obligations to a different supplier in the event if the original supplier is terminated / liquidated. Or the amount of compensation if the procuring entity does not agree to work with the newly assigned contractor.

The contract should also eliminate risks of any misinterpretation of the supplier’s obligations. All expenses included in the life cycle cost must be identified in the form of the supplier’s works/services, their frequency and scope.

The contract may also contain provisions on the evaluation/investigation of malfunctions and defects that occur after the end of the warranty period but still during the life cycle, regardless of whether they occurred due to inadequate maintenance or as a result of circumstances independent of the supplier.

The notion of statutory service life set by the manufacturer is also quite risky. Since the supplier does not essentially bear any warranty obligations except for reputational risks, they can deliberately claim an inflated service life.

In such cases, the procuring entity can determine the effective use period independently.

Say, the manufacturer set the service life of the product at 10 years. But the procuring entity believes that it makes more sense to calculate the life cycle costs for 5 years only. Afterward, costs can vary greatly depending on changing circumstances (such as the intensity of use). However, it is important that the procuring entity’s logic should be convincing and justified, without unfair preferences to one participant; otherwise it may give supervisory and law enforcement agencies a reason to recognize this as an abuse.

In any case, using LCC procurement requires detailed study of the market, experience with the use of this product, and due consideration of all risks.

MUTUAL SETTLEMENT

In LCC procurement, there is another inherent problem: the supplier is always interested in obtaining as much money as possible immediately. Therefore, they can intentionally drive up the product price and dump the life cycle costs, forcing the procuring entity to pay too much at once.

For example, there are two competitors, and there is a clear winner according to the life cycle cost assessment criterion:

Indicator	Participant 1	Participant 2
Product price	UAH 1,000,000.00	UAH 1,500,000.00
Life cycle cost	UAH 800,000.00	UAH 250,000.00
Cumulative cost	UAH 1,800,000.00	UAH 1,750,000.00

Participant 2 has a better offer, but by paying a much larger amount at once, the procuring entity bears greater risks, and this may be against their interests.

In order to avoid this situation, the tender documentation should specify a limit on the minimum share of the life cycle cost in the total value of the offer. This is best determined based on the market analysis.

For example, the buyer analyzed the goods on the market and identified that the average life cycle cost constitutes 60% of the initial cost of the product. This would be a good base limit for life cycle cost calculation by the participant.

It is also important to describe the process of mutual settlement during product use. The contract should determine not only the list of works to be performed by the supplier, but also the procedure for their confirmation, possibly fines if the supplier doesn’t deliver. This will mitigate the risk of the works included in the life cycle cost being executed poorly or not at all.

LCC PROCUREMENT IN ROAD REPAIRS

One example where life cycle costing procurement can be most effective is road works.

Procuring entities normally buy construction or repair of car roads as a separate service. The contractor is interested in minimizing their costs during the execution of the work, resulting in the use of low-quality materials or poor execution. Since construction works are by nature hard to verify after the fact, the procuring entity must ensure constant control over the implementation of works and integrity of oversight over construction. All life cycle costs are then ordered by the procuring entity separately in the form of maintenance and minor repair works.

However, by applying life cycle costing, the risks of low-quality performance of construction works rest entirely with the contractor, since it is the contractor who will have to maintain the object in a proper condition throughout the life cycle.

Thus, this method ensures a higher quality of works. The contractor is interested in performing the works with the highest possible quality in order to have minimal costs during the life cycle of the road. He or she therefore understands that if low-quality materials are used or the technology is violated, the road will be likely to become unusable prematurely. Then, the contractor will have to fix the defects, which may end up costing them a lot more.

Therefore, with the use of life cycle costing, the quality of road works directly affects the level of the contractor’s future expenses during the operational maintenance and repair of the road.

On the other hand, when repair work and operational maintenance are entrusted to different organizations, there is no motivation to do a good job.

However, for this method to be effective, the object’s condition should be monitored throughout the life cycle to verify whether it is in line with the requirements set.

SOME EXAMPLES OF THE BIGGEST LCC CONTRACTS

In 2016, the UK Government signed an £18 billion contract with EDF Energy to build a nuclear power plant, Hinkley Point C. The contract included life cycle cost analysis of various power plant projects. As a result, they chose the project with the best indicators of efficiency and cost.

In 2013, the New York State Department of Transportation (NYSDOT) awarded a $3.98 billion design and construction contract to replace the Tappan Zee Bridge over the Hudson. The contract included an economic analysis of various design options, which depends on the service life and costs during the life cycle of the bridge.

In 2020, Amtrak signed a $7.3 billion contract with Siemens Mobility to manufacture 83 high-speed trains for its national passenger rail service in the United States. The contract provided for the cost of all train life cycle costs for 20 years.

In 2021, the German energy company RWE signed a $4.3 billion contract with Siemens Energy for the supply of wind turbines for its offshore wind farm in the North Sea. The contract included a life-cycle cost analysis to evaluate different approaches to the task at hand.

In 2017, the US Army signed a $663 million contract with Caterpillar to supply construction equipment and related services for engineering and construction work. Different types of specialized equipment were compared based on their life cycle costs.

CONCLUSIONS

Life cycle costing is an effective tool that allows the procuring entity to evaluate a product not only in terms of its original cost, but also in terms of total foreseeable costs of its acquisition and value.

However, this tool is quite complex and requires much more effort from the procuring entity.

It is necessary to analyze the market, conduct pre-tender consultations, assess prospects and possible risks.

Here is an approximate guide for how the procuring entity should approach this:

1. Analyze the market for the availability of various products that meet the needs of the buyer.
2. Determine whether the life cycle cost is different for different products.
3. Determine whether the life cycle cost is significant in relation to the price of the product.
4. Understand whether the life cycle duration can be objectively established, and whether the life cycle costs are foreseeable.
5. Determine which components of the life cycle cost are relevant/possible to include for comparison (resource consumption, replacement of consumables, maintenance, termination of use, etc.).
6. Determine the risks and compare them with the expected benefit, and make a decision about the feasibility of using this approach.
7. Determine the procedure for calculating the life cycle cost by the participants.
8. Determine whether the effective period of use is the same for different products, and whether it is necessary to use the adjusted life cycle unit.
9. Define criteria for participants to minimize the risks of inadequate life cycle support.
10. Develop a draft contract that will minimize risks and provide for supplier liability mechanisms.

This publication was prepared with the financial support of the European Union. The contents of this publication are the sole responsibility of Transparency International Ukraine and do not necessarily reflect the views of the European Union.