Thinking Like a CFO: Mastering a Fundamental Tool
It’s an old story for seasoned facility executives. Given a choice between two assets to be purchased, management would rather go with the one that costs less. The problem with that approach is obvious: When utility and maintenance costs are factored in, the lower-priced item may cost more in the long run. But convincing management that the more expensive item is a better value can be impossible if the facility executive cannot present the type of financial analysis that management demands.
In some cases, a very straightforward comparison suffices: Simply add annual maintenance costs and annual energy costs, then multiply by the expected useful life span of the asset and add that total to the purchase price. But in many cases that sort of analysis isn’t enough. Often, several options are being evaluated, some with different life spans. In those cases, it is necessary to extrapolate the costs on a per-year basis for each option, dividing the total cost arrived at by the number of years the asset is expected to remain in service. This concept is commonly known as total cost analysis.
Although that approach presents a far more accurate picture of the financial implications of each option than a simple comparison of first costs, it leaves out a concept that is very important to financial managers: the time value of money. Management often evaluates purchases in terms of today’s dollar or present value. The concept is simple: A dollar today has more value than a dollar next year because the future value of a dollar erodes each year due to inflation and lost “opportunity cost.” These dynamics are considered when net present value is used to calculate life cycle costs.
This may seem like an unnecessary — and somewhat intimidating — step that adds little value to the decision-making process. But a net present value analysis is a fundamental tool that financial managers use to make important financial decisions. By learning to speak their language and present options in a way they understand, facility executives have a far better shot at persuading management to make the right decision, even if it is initially the more expensive decision.
Let’s consider an evaluation of two options, each with different initial purchase prices, useful life spans, maintenance costs and energy costs. In this example, the building has six 50-ton rooftop units that need replacement. Instead of simply replacing the rooftop units with updated models, the facility executive wants to explore the installation of a single 300-ton chiller to service the entire building. This option is initially more expensive and will likely be met with resistance from management. The facility executive believes that, although a chiller is more expensive initially, it will be a much less expensive option over the life of the asset. The details of each option are shown in Table 1.
Table 2 represents a running total of expenses for both options. The last column (PV$) identifies the present value in dollars. That number is derived using an annually decreasing factor (PV Factor). The PV factor is a discount factor, which establishes future costs in today’s dollars. It is derived from a financial calculator and is typically supplied by an organization’s financial department. Factors that determine the value include profit margin, interest rates on loans, return on investment and opportunity costs.
It is also important to note that both the maintenance costs and utility costs are subject to an annual 4 percent increase, which is included in the analysis. Year 10 shows an expense of $169,573 for a major overhaul of the chiller system based on the manufacturer’s recommendations. The present day price of this overhaul is $112,881, but it must be escalated 4 percent per annum to accurately reflect the rising cost of parts and labor.
Table 2 also shows the life cycle cost of Option 2, the six 50-ton package units. Year 10 includes an expense of $392,747 for replacement of all six units. The present day price of this replacement is $265,326, but again it must be escalated at 4 percent per annum to accurately reflect inflation of parts and labor.
And the Winner Is. . . .
The net present value analysis shows that Option 1, although slightly more expensive in initial price and annual maintenance and utility costs, is actually less expensive over the term of its useful life. Option 1 represents a savings of nearly $41,232. Armed with this information, management can make informed economic decisions that actually save a substantial amount of money.
When attempting to perform a total cost analysis or a life cycle cost analysis, facility executives will need to access a source of benchmarked numbers for initial purchase price and the ongoing price of maintenance. The R.S. Means Facilities Maintenance & Repair Cost Data book is one resource for these benchmarked prices. It includes information on hundreds of different assets.
If facility executives see decisions about purchasing assets the way that management does — as financial investments — the result will be better decisions. Resistance from management will dissipate as facility executives become more adept at highlighting the long-term strategic benefits of an initially more expensive purchase. Life cycle costing based on a net present value analysis provides facility executives with a method to compare two different types of assets with two very different life spans. Using life cycle costing, the facility executive can provide management with an equitable comparison of options using their preferred method of comparison — today’s present value of money.
David Casavant, CFM, is president of the Carlyle Consulting Group, a business consulting firm specializing in workplace productivity, process re-engineering and transition management in the real estate arena. The Carlyle Consulting Group also performs and teaches facility management organizations how to conduct life cycle cost analysis and other cost-saving analyses.