WHOLE LIFE COSTING

General Principles
This guide introduces the following general principles of whole life costing.
Essentially, whole life costing is aimed at answering the question What is the cost of
achieving this objective in this way? rather than the more limited question What is
the cost of buying this item? However, this question will be relevant at many stages
throughout the procurement process from consideration of the initial business case
to evaluation of tenders.
In deciding on which option to select for meeting a need or providing a service, it is
essential to consider all the costs involved in each option.
Some of these costs will be incurred at the outset, when equipment is bought or
initial payments are made for service contracts. However, many of the costs will
only arise over the life of the option, for example, as a result of running costs,
including energy costs, equipment maintenance costs, staff training and disposal
costs of both the old equipment and the new equipment at the end of its working
life.
It is important to think in terms of meeting identified needs rather than in terms of
acquiring particular assets (eg lease versus buy). When deciding how to meet a
need, the options considered should include all the practicable ways of meeting
that need. An item which has ordinarily been used to achieve this may not
actually be essential for meeting the objective.
Cost is not usually the only criterion on which the different options should be
evaluated. There will also be considerations of the quality of the product or the
service provided. Sometimes there will be minimum quality standards to be met.
In other cases, different solutions will offer different advantages. Some of these
advantages will relate to quality and others will relate to cost.
Costs arising from impacts on the environment, such as clean-up costs, may form
part of the cost in the initial business case. This will then be reflected in the
specification.
Environmental issues must be taken into consideration in the business case and
specification, independently of costs, for example to meet the Executives policy
and objectives on environmental issues, particularly where there is clear
government policy, such as on paper or timber purchases or a clear Executive
policy.
Further guidance on environmental policy in procurement can be found at:
http://www.scotland.gov.uk/about/FCSD/PCSD-POL/00017839/susdevguide.aspx
1.
Introduction

This guide explains the concept of whole life costing, its purpose and its place in
purchasing decisions. Although the guide is primarily aimed at public sector bodies,
the principles of whole life costing are the same for all organisations, whether public
or private sector.
Essentially, whole life costing is aimed at answering the question What is the cost of
achieving this objective in this way? rather than the more limited question What is
the cost of buying this item? However, this question will be relevant at many stages
throughout the procurement process from consideration of the initial business case
to evaluation of tenders.
The cost of achieving an objective differs from the cost of buying an item in two
ways. First the purchase of goods may not be necessary to the achievement of the
aims identified. For example, they may be available for hire or a different good may
do the job just as well. Second, the purchase price is unlikely to be the only cost
incurred as a result of the procurement. For example, there may be fuel costs and
maintenance costs and there may be a cost incurred on disposal.
Determining the full cost of a method of meeting a given requirement involves an
understanding of how the eventual solution will be implemented. It is always
necessary to consider what the procurement is supposed to provide, the cost of the
solution and the relative costs of meeting the requirement in other ways.
Although whole life costing deals with the cost of the requirement over its total life, it
should be remembered that different solutions may have different life spans. The
cost of the chosen solution should therefore be annualised to enable the costs of
different solutions to be properly compared (such issues can arise either at the initial
business case or at the evaluation stage).
For example, a bus with automatic transmission which has a whole life cost of
270,000 and a life span of 15 years has an annual cost of 18,000. A bus with
manual transmission which has a whole life cost of 200,000 but a life span of only
10 years has an annual cost of 20,000. The bus with the higher whole life cost has
the lower annual cost.
The life span of a solution will, of course, depend on the length of time the solution
is needed as well as its durability. In the above example, if the bus was only needed
for 10 years and the total cost of using the bus with automatic transmission for the
first 10 years would be 210,000, the bus with manual transmission would deliver
better value for money.
2.

The Full Cost of Using an Item

The cost of using an item can be broadly divided into three categories: acquisition,
running and disposal costs. Acquisition costs are incurred before the solution is
ready for implementation. Running costs are incurred as a result of actually using it
or keeping it available. Disposal costs are incurred on disposal or when dealing with
site contamination or other harmful effects. There may also be some income that will
be realised on disposal if there are assets with a resale or residual value. This and

any rental income when assets are not in use can be offset against the costs in
determining the whole life cost.
Figure 1 provides some examples of each of these types of cost1, although this is not
an exhaustive list.
Figure 1
Costs of Ownership
2

Purchasers Legal Costs

Purchase Price/Rent/Hire Purchase
Fees to Copyright Holders
Cost of Transportation to Site
Preliminary Inspection Costs

Cost of Writing Specification

Software Licences
One-off Operators Licence Fees
Installation Costs
Sustainable Development Costs

Insurance
Annual License Fees
Fuel and Electricity
Periodic Inspection Costs
Sustainable Development Costs

Accommodation
Operatives Wages and Salaries
Cleaning Costs
Spare Parts and Other Maintenance Costs

Sellers Legal Costs

Cost of Transportation from Site
Site Clean-up Costs

Costs of Removing Installations

Refuse Disposal Charges
Sustainable Development Costs

Some of these may not be admissible as cost criteria in public sector procurement procedures, as they may give
an unfair advantage to an existing supplier or contractor.

3.

Whole Life Costing and Value for Money

Whole life costing must be used in the context of the need to obtain value for money
(vfm) in public sector purchasing decisions. Cost alone, even whole life cost, does
not capture all of the information relevant to a purchasing decision. Value for money
does not simply mean selecting the cheapest option which meets the minimum
requirements but is defined as the optimum combination of whole life cost and
quality (or fitness for purpose) to meet the customers requirement.
Price will usually be only one of a number of criteria used to evaluate tenders and
therefore whole life cost and quality should be used to determine the value for
money of each option. The detailed criteria should be published in the contract
notice and contract documents, to ensure that all potential bidders have equal
access to full information about the tendering procedure, including the evaluation
criteria to be applied, and to enable them to improve the quality of their bids by
adapting them to the actual requirement. The criteria for deciding which delivers the
best vfm (in EC terms: most economically advantageous tender) include quality,
price, period for completion, running costs, profitability and technical merit.
In cases where there is a range of acceptable quality, a formal scoring system
should be used to allow an objective and informed decision to be made. This is
likely to involve giving each option a score for each criterion and then multiplying
each score by a weighting factor reflecting the relative importance of the respective
criterion. This is explained more fully in the Bid Evaluation section of the Scottish
Procurement Toolkit.
4.

Environmental Costs

Another aspect of whole life costing at initial business case stage is that not all the
costs of using an asset or of receiving a service are borne by the user of the asset or
service. There may be damage to the environment the cost of which is borne by
neither the provider nor the user of the asset or service. The European Commission
has issued guidance3 on the possibility of taking account of environmental criteria in
the procurement of supplies, works and services, Commission of the European
Communities, Commission Interpretative Communication COM(2001) 274
(Final),2001 www.europa.eu.int.
It is important to understand that the policy of achieving value for money applies
particularly to the award stage of the procurement process. It is for the customer to
decide what to buy and to set the specification, in the context of their overall
operational and policy objectives, including the Scottish Executives objectives on
environmental matters, and subject to the normal public expenditure tests of need,
affordability and cost-effectiveness. It is at this early specification stage that there is
most scope to consider environmental issues. There is a clear distinction which is
often not understood - between what can legitimately be done at the specification
stage and what can legitimately be done at the award stage.
Specification Stage

Public sector bodies may frame the contract specification in such a way as to ensure
that the work will be carried out in an environmentally sound way. For example a
customer can choose to specify and purchase low emission vehicles (even where
they might be more expensive than standard vehicles). Value for money must be
achieved, however, in the contract award process, i.e. the contract should be
awarded to the bidder offering the best combination of whole-life cost and quality to
meet the requirement for low emission vehicles. And the requirement itself, for low
emission vehicles, must be tested for need, affordability and cost-effectiveness in the
context of the customers overall objectives. However, this is a matter of prudent
financial management generally rather than specifically one of procurement policy.
However, the specification must not be drawn up in a manner which frustrates the
purposes of competitive tendering by unfairly restricting the tendering process to a
single supplier or to a narrow group of suppliers or to suppliers from one country or
locality. In other words, materials should not be specified which are not widely
available and, in addition, prospective contractors should be allowed to substitute
other materials which will still meet the customers environmental objectives in an
equivalent manner.
Award Stage
All tender evaluation criteria used must be justified by the subject of the contract.
The purpose of the award stage of the procurement process is to allow the
contracting authority to assess which tender best meets its needs. The evaluation
criteria chosen should help the authority to do this. They should relate to the intrinsic
qualities of each of the bids when compared to the stated requirements of the
contract, and not to secondary issues, such as external costs or benefits. This is
what is meant by criteria having a direct link to the subject of the contract. In such
cases it is essential, in order to meet the ECs overarching principle of transparency
(which applies to all procurements, whether they are above or below the EC
thresholds) that it is made clear at the outset that the environmental characteristics
of the goods being procured will be part of the evaluation criteria. The award criteria
must be mentioned in the contract notice or contract documents. They should be
listed in descending order of importance. It is good practice to also include the
relative weighting given to each of the criteria. This is a requirement of the new
consolidated EC procurement Directive.
Further information on public procurement and sustainable development, and
guidance for buyers is available at
http://www.scotland.gov.uk/about/FCSD/PCSD-POL/00017839/susdevguide.aspx

5.

Decisions on Environmental Policy and Standards

Figure 2 illustrates the process whereby environmental costs could be included in

whole life costs. Essentially, this would be achieved by environmental regulators and
other central government bodies ensuring that such costs were no longer
externalities by means of environmental taxes and regulations which made polluters
pay the cost of environmental damage prevention or environmental restoration or an

amount reflecting the value placed by the regulator on the environmental loss
suffered.
The purchasing body may choose to specify requirements which go beyond those
laid down by legislation. In doing so, it must ensure that it complies with all relevant
laws and regulations (e.g. does not unfairly discriminate) and must be prepared to
justify any associated cost premia.
A public or private sector body making purchasing decisions may wish to have its
own environmental policy or guidelines. As a minimum, all public and private sector
bodies must comply with current legislation. However, an environmental policy
should go beyond this and detail any additional requirements that senior or top
management deem appropriate and this policy should be disseminated.
When an item of work is planned and the decision is taken, either voluntarily or in
compliance with legislation, to invite outside tenders for the work, the buyer and the
Customer will draw up a general specification of the work to be done, ensuring that
the nature of this work does not, of itself, breach the Executives own environmental
policy or regulatory standards. The purchasing department, in consultation with
other managers, will then draw up a detailed specification which ensures that the
objectives set out in the outline specification are required to be met while at the
same time laying down any specific requirements necessitated by the environmental
policy.
It is then a matter for prospective suppliers competing for the work to ensure that
they comply with all laws and regulations and while meeting the requirements of the
purchasing specifications and pay all environmental taxes resulting from their
activities. The costs of compliance with regulations and the amount of environmental
taxes will have an impact on the price which suppliers will need to charge for the
work.

1.

Figure 2
1.1
A Structure for Including Environmental Costs in the Consideration of Contract

1.1.1
reen

Senior
Management/
End User

Purchasing
Department

Ministerial Direction

Environmental
Regulations
Environmental
Policy

Environmental
Taxes

Outline
Purchasing
Specification
Detailed
Specification
Proposals and
Tender Prices
Contract
Award

The purchasing department will make a decision on the basis of a number of

previously notified criteria, including the full cost to the purchasing body of each of
the proposals. This cost will include both the price stated by the bidder and any
additional costs which the purchasing body will have to bear. These additional costs
may include costs of environmental taxes and costs of compliance with
environmental regulation which will fall on the purchasing body rather than the
supplier. Different proposals may involve different customer-side costs.

6.

The Contract Specification

The contract specification is the key document in the procurement process. This is
the description of the goods or services, which is drawn up before tenders are invited
for the work. A contract specification must state in all necessary detail the goods,
services or works which are required, the dates on which they must be delivered or
(in the case of services) the periods during which they must be delivered and the
locations at which they must be delivered.
A clear and adequate contract specification is essential for any life cycle costing
exercise. Both the customer who will actually use the goods or services and,
especially if the user department is a support service department, those departments
which will rely on the operations of the user department, should be involved in the
drafting of the contract specification. For example, in the case of a maintenance
contract for computers operated by a local authoritys central IT unit whose duties
include providing housing benefit calculations to the finance department, the IT unit
must consider the possible effects of different patterns of scheduled downtime on the
units ability to carry out its work. The IT department must then inform the finance
department of the effects of different downtime patterns on the authoritys ability to
process new claims, amendments and cancellations within an acceptable time
frame. The finance department can then consider which downtime patterns are
acceptable and this can be stated in the contract specification. The contract itself
should also lay down remedies for excessive downtime.
The specification needs to focus on the outcomes which must be achieved by the
contractor. This will enable invitations to tender to focus on the provision of the
goods, services or works which the purchasing organisation actually needs.
There may, of course be more than one method of meeting the Executives
requirements. In this case, some choice will have to be made about the method of
service provision before the invitation to tender is drawn up. For example, there may
be a requirement for office accommodation which could be met by leasing
accommodation, buying and refurbishing existing offices or having new offices built.
The decision will have to be taken on whether or not paying for the construction of
new offices is likely to provide better value for money than buying or leasing existing
accommodation before tenders are invited for construction work.
7.

Using Discounted Cash Flows in Costing

One final point must be made about whole life costing. Because it deals with
payments and receipts over a long period of time, it is necessary to make
adjustments for the time value of money. Payments to be made in the near future
are held to have a higher Net Present Value than payments to be made in the distant
future when calculating whole life costs of projects because they affect the amount of
resources available in the short term. It is often more useful to have resources
available in the short term than in the long term because of the knock-on effects of
short-term expenditure on the future. Cash inflows and outflows are adjusted to their
Net Present Value by multiplying them by a Net Present Value factor which is lower
the further in the future the cash flows will be. The use of discounted cash flows is
explained further in the Annex A.

Summary
Whole Life Costing aims to determine the full cost of a solution to a requirement
over the full period that the requirement will exist.
Whole Life Costing can be applied to leased assets as well as to owned assets
and can be used to compare the cost of leasing and outright purchase.
Whole Life Costing should be seen as a means of costing different methods of
achieving an objective. This means that a project specification should be drawn
up which clearly identifies what objective is to be achieved before a decision is
taken on how to achieve it.
Whole Life Costing should form only one element in purchasing decisions, which
should also reflect quality considerations and may reflect environmental and
social consequences which do not give rise to costs to the purchasing
organization. However, considerations of quality and of environmental and social
consequences must not be allowed to give rise to anti-competitive purchasing
procedures.
In taking these factors into consideration, public sector
organisations must also act within a clear policy framework and comply with the
law and regulations.

Annex A - Using Discounted Cash Flows in Costing

A complication which arises in calculating the whole life cost of an option is the time
value of money. Essentially, it is more advantageous to receive money earlier rather
than later and to pay money later rather than earlier. This is because the cash which
has been received can be spent on other projects which help to achieve the
organizations aims or alternatively invested to earn interest or used to pay off debts,
thereby reducing interest expenditure. In the same way, cash which does not have
to be used to make a payment can be used for other purposes.
This is illustrated by the following example:
A manufacturing company presently makes a profit of 2 million per annum. The
company has decided to build a new factory, costing 10 million to assemble white
goods. The company has an offer of a loan of 10 million to enable them to build
the factory now (Option A). Alternatively, they could wait five years and use the
profits generated in the intervening period to build the factory (Option B). They
expect to make a profit of 2 million per year from the products made in the factory.
When the factory has been in operation for twenty years, it will be replaced by a
newer, larger and better factory paid for out of the earnings it has generated. If the
company take out the loan, they will be required to pay it back in five years time. In
the meantime, they will pay interest of 1 million per annum.
Whichever option is chosen, the company will have to make a one-off payment of
10 million in five years time, either to build the factory (Option B) or to pay off the
loan (Option A). However, if the company borrows the money and builds the factory
now (Option A), they make 1 million more profit every year (after interest) for the
next five years. They will also be able to build the next factory and thereby increase
their profits further, five years earlier than they would be able to do if they waited to
pay for the factory out of profits (Option B).
This means that at any given moment in the future, the company will have generated
more money if they chose Option A, giving them the money now, than if they choose
Option B, giving them the money in five years time.
Moreover, if the company had sufficient money right now without having to borrow it,
then their future profits would be even higher, because there would be no interest
expense.
In other words, there are advantages to having money now rather than in five years
time. In the public sector, the benefits of having more money now are likely to be in
terms of providing better services, treating more patients or making more savings
earlier, rather than in terms of income generation but the principle will still be the
same. At any given time in the future, you are likely to have achieved more if you
have the same amount of money now instead of in five years time.
The extent to which it is desirable to have the money now is determined by the
extent of income generated, costs saved or benefits obtained, compared with the
interest cost. If, in the above example, the factory was only expected to generate

500,000 per annum the interest cost under Option A - the cost of using the money
or cost of capital - would have outweighed the gains from building the factory earlier.
In order to take account of the cost of capital in making decisions about spending
money, a notional interest rate, known as the discount rate, is used. The net cash
inflows (such as the profits from the factory) or outflows (for example the loan
repayment) for each year are multiplied by a Net Present Value (NPV) factor to give
the Net Present Value of the cash flows. Each years NPV factor is calculated by
dividing the previous years NPV factor by one plus the discount rate expressed as a
percentage. For example, if the discount rate is 6%, the NPV factor for the first year
(usually called Year 0 in NPV calculations) will be 1, the NPV factor for the next year
(Year 1) will be (1 1.06) = 0.9434, the NPV factor for Year 2 will be (0.9434 1.06)
= 0.8900, the NPV factor for Year 3 will be (0.8900 1.06) = 0.8396 and so on.
The use of discounted cash flows is a necessary adjustment to whole life costing.
However, the general principle of whole life costing, namely that every significant
cost of every option must be assessed in deciding which option is the cheapest, is
far more important.