Application of Life Cycle Costing in Defence Acquisitions
Businesses objectives are typically divided on functional lines – investment, operations, maintenance and discard or obsolescence management. Usually, each of these functions have different objectives which leads to sub-optimal performance as well as wasteful expenditure and budgetary overruns. Therefore, there is a requirement to adopt an ‘integrated view’ of all these functions and identify cost drivers holistically, so as to optimise expenditure and ensure cost-effectiveness in any product development. In complex products, the integration of the individual sub-systems from the cost viewpoint does result in reduction of total cost of investment over the product life cycle. Investment decisions are increasingly focusing on total costs, which includes indirect costs, rather than only on the cost of acquisition. The catalyst for this are growing energy, material and labour costs coupled with an uncertain economic environment.
The system of Life Cycle Costing (LCC) has been in use for quite some time mainly in developed countries during acquisition process by Governments as well as by large corporations. The concept of LCC in product acquisition process originated in USA, specifically by the Department of Defence in the 1960s. LCC is finding increasing usage as a systematic approach to ascertain total life cycle cost of equipment. Life Cycle Costing has been variously defined with the life cycle cost of an item taken as the “sum of all funds expended in support of the item from its conception and fabrication through its operation to the end of its useful life”. The other two costing methodologies used, similar to LCC, are Total Cost of Ownership (TCO) and Life Cycle Assessment (LCA). However, TCO is used for supplier selection and supplier evaluation focusing on transaction costs wherein operational costs are not considered. LCA is based on environment imperatives rather than on cost estimates.
In essence, LCC may be said to be the total cost in acquisition, establishing a robust logistics base and sustaining it at a high level of operational availability over the life of the system and subsequent disposal and salvage. Although interest in LCC began in the 1950s through conceptual studies and research papers, it was in the early 1970s that the concept saw practical realisation in acquisition planning of weapon systems by the US Government Department of Defence. LCC is being used as a matter of course by militaries of developed countries in complex weapon system acquisitions mainly by US DoD and NATO members.
Modern military systems are complex being multi-technology based, often with multi-mission capability, comprising in itself complex sub-systems and components having to meet military specifications. These factors, along with the need for extensive evaluation and technical trials and often involving a long acquisition process, make military systems costly and evaluating commercial aspects do present unique challenges.
Peculiarities of ‘Defence Markets’
Some of the commonly used criteria for evaluation of weapon systems are operational readiness, life cycle costing, reliability, maintainability and ease of providing logistics support. While most of these factors are evaluated based on models derived from available empirical data and experiential knowledge, it is the paradigm of LCC which involves a complex and multidimensional process.
Defence acquisitions are a multi-stage process involving innovative R&D solutions, prototype development, staged production, extensive trials in different terrains and necessity to provide MRO support which often includes complex Maintenance Transfer of Technology (MToT). Defence OEMs have to, more often than not, plan for obsolescence management which includes in-service assembly level technology refresh and upgradation. Adding to these challenges is the aspect of changing security environment which contributes to uncertainty in procurement process increasing business risks faced by defence OEMs.
A contemporary trend in development of multi-technology weapon platforms is that of outsourcing or sub-contracting which may be as much as 50-60% of the weapon system. Also, upgradations and retro-fitment may be offered by defence companies who are not the OEMs which makes long-term budgeting and cost estimation a complex process. Interestingly, the acquisition cost of any weapon system is only a function of the total costs incurred in the life cycle of the system which has been called the “iceberg” effect which actually indicates that the majority of the costs are not visible. It has been commonly observed that 70-90% of the total life cycle cost of a product is established at the design stage itself. Even though expenditure incurred during the life cycle of any platform is many times the initial acquisition cost, it is the latter cost which is mostly used in procurement decisions.
This leads to the belief that ‘defence markets’ are substantially different from commercial industry transactions in terms of availability of fewer defence manufacturers and a unique procurement process with enhanced risks and uncertainties.
Essentials of LCC
Broadly speaking, LCC can be divided into four cost elements corresponding to various stages of the life of the equipment-Research and Development, Production, Operation and Support and Retirement and Disposal (Figure 1).
A significant consideration in LCC is that the total life cycle cost of an equipment is dependent on its reliability and ease of maintenance and repair, factors which should essentially be addressed during the research, design and development stages of the equipment. The R & D cost includes hardware and software design, system integration as well as ensuring ‘design to cost’ or affordability. The LCC also encompasses cost of verification, evaluation and trials. Design-to-Cost (DTC) is a concept which is used to identify cost from the product design perspective incorporating issues of performance, capacity, reliability, maintainability etc.
Since the 1970s, US Army has been carrying out ‘Logistics Supportability Testing’ which involves operational testing for maintainability and reliability of weapon systems and equipment at the development stage itself. This realistic assessment carried out at this early stage in the life cycle of a weapon system is an imperative which actually would lead to large savings in MRO activities later on during operational exploitation of the equipment.
The relationship between product procurement cost, its logistics cost and resulting LCC is depicted graphically in Figure 2. It is highlighted that as product reliability efforts are enhanced the procurement cost increases, however, the logistics cost (for operation, maintenance and repair) decreases substantially and overall, there is an optimum point beyond which enhancing product reliability does add to LCC of the product.
LCC is essentially a decision support tool to select a product among competing alternatives and options empowering managers in the following scenarios:-
• Assessment of future expenditure.
• Selection process in procurement cases.
• Evaluation of cost reduction options.
• Identifying cost drivers in equipment acquisition based on a given user requirement (eg. GS QR).
• For audit purposes or identifying Key Performance Indicators (KPI).
LCC is not only being used while evaluating systems for procurement but also to analyse future costs for budgeting purposes during the early stages of the life cycle of any equipment. It has been well established that life cycle costs can be reduced substantially during the initial stages of acquisition - project definition, design and development, production and initial exploitation. In this case, the application and accuracy of any LCC model is based on the quality of data available and a rigorous data collection methodology. LCC studies are usually undertaken with the following objectives:-
• To decide on whether to ‘buy’ or ‘make’ or ‘lease’.
• Budgeting, including forecast of capital and revenue expenditure.
• To provide estimation of in-service costs associated with specific activities so as to plan Maintenance, Repair and Overhaul (MRO) interventions and discard of the system.
• Enables collection and recording of data which can provide a basis of LCC studies of similar systems in the future.
• Cost monitoring and for auditing at various stages of system life cycle.
• Identifying ‘value added’ and ‘non – value added’ activities as part of Activity Based Costing (ABC) method.
LCC can also be applied for Product-Service Systems (PSS) and this is gaining relevance since increasingly, defence manufacturing companies are offering end-to-end holistic in-service support in terms of MRO, upgradation and obsolescence management. However, LCC models in case of services (PSS) are quite different from that used for products.
The LCC analysis of any weapon system is an elaborate and complex process as has been highlighted in the preceding section. While there are several models which have designed to make the LCC analysis streamlined, a broad framework which is commonly used to systematically assess LCC of a system (depicted in Figure 3) is as follows :-
System Definition. Identifying cost characteristics, sub-system wise and activities in the product life cycle which generates cost. This stage also includes categorisation of such activities and relating costs to specific accounting heads which is formally called the Cost Breakdown Structure (CBS).
Cost Estimation Relationships (CER). Each of the entities in the CBS is related to the major cost drivers.
• Development of LCC Model.
• Normalisation of the costs based on the LCC model, to account for discounted costs, cost escalation and foreign exchange variation as applicable.
• Identification of cost drivers and optimisation, as necessary.
Cost Breakdown Structure (CBS) is a fundamental step in the LCC process and is a framework for defining life-cycle costs providing inputs for cost reporting, analysis and control. In each of the stages of the life cycle of a system, there are various associated costs and LCC method is effective only if a detailed, cost breakdown structure, incorporating all activities, is available.
Cost estimation techniques can be classified broadly into two categories qualitative techniques and quantitative techniques. Qualitative techniques may be either intuitive or analogical in nature while parametric and analytical techniques constitute quantitative techniques. These techniques are briefly explained as follows:-
• Intuitive – Expert opinion and experience dictates cost estimates.
• Analogical – Estimates are based on data available for similar systems which has been evaluated in the post.
• Parametric – Also known as ‘top-down’ applications and is an analytical function of parameters used to define the characteristics of the product.
• Analytical – In this ‘bottom-up’ technique, the estimate commences with the component level analysis and aggregated to the system level.
The decision to adopt any of these techniques for a LCC analysis is based on the relative merits and demerits of each, essentially based on tolerance for bias and error, time available, availability of data, technological complexity of the system and degree of environmental risk and uncertainty.
In effect, the LCC process commences with identification of all activities, both direct and indirect, which make up each stage of the product life cycle. A pragmatic approach is to incorporate associated risks which may impact each stage of the system life cycle which results in a ‘risk adjusted’ cost. Data collection may be done through a variety of means such as market survey, reliability analysis and information available from similar systems already in service. An important source of data is from manufacturers, obtained through relevant RFI/RFPs.
There have been various models used in the LCC process, based on quantification of inputs available and estimation procedures, the latter ranging from an ‘educated guess’ to complex mathematical techniques. However, practitioners of LCC process in military system procurement have noted that a LCC model has to be essentially tailor-made to meet specific requirements and unique attributes of a particular weapon platform. Various costs such as those related to development, investment made, operation etc. are estimated within a framework of experimentation, relationship within system parameters, intuition and assumptions, which has led to the cost analysis through LCC being described as an ‘art’ rather than following any stringent methodology.
It is at the early stages of exploitation of a weapon system, that the associated uncertainty, risks and opportunities are maximum which in turn makes the collection of multi-dimensional data an imperative in using any LCC model. The success and accuracy of forecasting through LCC is dependent on the data available and method employed in carrying out the process.
Imperatives of LCC Implementation
A NATO study on various LCC models, highlighting the need for standardisations of the process, has made the following pragmatic recommendations to be kept in view during implementation of LCC process:-
• LCC is multidisciplinary process involving costing specialists technical experts and experienced users.
• Assumptions made in cost estimation and the process adopted should be well documented.
• The ‘affordability’ factor should be carefully analysed at all stages of the product life cycle and this includes balancing between cost and desired performance parameters.
• Cost breakdown analysis should preferably be done using two different models to ensure validity of the results.
• LCC of military systems should be accompanied by a risk and uncertainty analysis and its impact on life cycle cost estimates.
• LCC of software is complex and there are many imponderables in the kind of system architecture and software development process.
Application of LCC in Indian Defence Acquisitions
In developing countries, military acquisitions often pose a decision dilemma whether to develop a system indigenously or buy it outright mostly from foreign defence manufacturers. This is commonly referred to as the ‘Make or Buy’ decision and impacts the LCC process to be followed.
The difference between these two LCC models is due to the stages of the life cycle, availability of data and the very purpose of carrying out a LCC process. For example, in a ‘buy’ case the LCC would be used for choosing between competing alternatives and in a ‘make’ case the focus would be on programme budgeting and balancing between desired weapon performance parameters and cost as also carrying out a cost-benefit analysis.
In the Indian context, weapon platform purchases (‘Buy’ category), may not be outright purchases but could be through a DPSU being nominated as a designated production agency which would, in all probability acquire the system in Fully Formed, Semi Knocked Down (SKD) or Completely Knocked Down (CKD) condition and may also acquire rights to manufacture some components or sub-systems. In such a scenario, the Cost Breakdown Structure would include cost of imported items, indigenous content, labour, proof trials, profit etc. These aspects are deliberated in much detail by the Commercial Negotiation Committee (CNC).
Acquisitions of military systems, the world over, have indicated substantial cost escalation as compared to initial estimates by as much as 25% at times. India is the world’s largest arms importer with a share of 15% of the total international arms imports between 2010-2014 with China’s and Pakistan’s share at 5% and 4% respectively. This large expenditure in the face of shrinking defence budget and resulted cost consciousness makes, LCC an important decision-making paradigm.
The Committee on Defence Procurement Procedure (DPP), set up to make recommendations as a prelude to formalisingthe DPP-2016, recommended LCC as an “apt tool for all high value assets” such as aircrafts, helicopters etc. The Committee justified this by noting that “for very high value assets of the Services, which demand very high level of operational availability as well as mission capability, decisions based purely on ‘acquisition cost’ model may not be most optimum”.
In an environment where the budget outlay for capital acquisition of weapon platforms and equipment is constantly under strain, LCC concept provides an appropriate and effective method in analysing competing systems and also in financial forecasting. LCC is not only relevant during the initial stage of an equipment’s life cycle but should be perceived as a continuous process in order to evaluate environmental and other factors as well as identify areas for cost savings. With the rising cost of defence products and shrinking budgets combined with increased competition and inflation, rising costs of operation and maintenance there is heightened interest in LCC analysis. Early application of LCC ensures that various cost drivers can be optimised for example at the design stage itself and this can prevent a cascading effect in cost increase along the life cycle stages of a system. (See LCC methodology chart).
LCC as a process is complex requiring numerous inputs from a multitude of stakeholders, thus requiring considerable resources and effort. Therefore, LCC is recommended only for large defence projects and weapon platforms such as Armoured Fighting Vehicles, Ships and Aircraft which are going to be the mainstay in terms of operational capability, for a considerable period of time. LCC estimation enables a structural methodology for balancing of total cost of ownership with the performance, operational and logistical requirements expected from the system.