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Life Cycle Costing: Value for Money

By Air Marshal (Retd) Anil Chopra
By Air Marshal (Retd) Anil Chopra


For years, for capital procurements, the country had been following a ‘Single-Stage Two-Bid System’ wherein both the technical and commercial bids were submitted simultaneously. The technical aspects were subjected to detailed evaluation following which commercial bids of only those that were technically compliant were considered by the Contract Negotiation Committee (CNC) for determination of the ‘lowest bidder,’ popularly known in the corridors of power as the ‘L1’.

The L1 was determined on the basis of ‘procurement cost’ of items contracted. Although this process ensured induction of the cheapest equipment, it did not address the issue of very high cost of operation over its life-cycle which depends on the type of technology and design philosophy. Employment of better technology and design would reduce operating costs over the life-cycle of the equipment.

In our personal life, when we want to buy a car we don’t look at only the initial cost, we go into details of running expenditure such as fuel consumption, cost of spares, repair and servicing facilities across the country, etc. That is one of the reasons why diesel cars are so popular in India in spite of higher initial cost. That is what lifecycle cost (LCC) model is all about.

Dassault RafaleLCC Model

LCC is defined as the sum of all recurring and non-recurring (one time) costs over the full span of planned utilisation period. LCC includes the costs of procurement, installation, operation, maintenance and also factors in the residual or salvage value recoverable at the end of useful life. It is thus the cost of ownership over the full life. The LCC model in different forms has been adopted since the 1980s by Austria, Germany, Iceland, the Netherlands, Switzerland and the United States. Australia has a Parliamentary Act mandating the use of LCC for all public procurements. The concept is known by various names such as LCC, cost of ownership (COO) and the total cost of acquisition (TCA). More than 19 internationally reputed vendors have responded to the Indian Government RFPs with the TCA model. No vendor has raised any issue or expressed lack of clarity on the subject.

The LCC analysis is carried out using the defined procurement objectives, cost drivers, established parameters, escalation methodology, discounting rate, etc. The methodology is stated upfront in the RFP. The Indian Defence Procurement Procedure (DPP) has been gradually moving towards LCC since 2002. A committee was formed by the Ministry of Defence (MoD) in 2007 with members from MoD (Finance) and the Air HQ to suggest a suitable model for the medium multi-role combat aircraft (MMRCA) case.

The committee recommended inclusion of all major elements that were quantifiable, verifiable and relevant. They proposed a TCA model for inclusion in the MMRCA RFP. Finally all the determinable factors, including the operating cost and MTB-linked warranty were included. The TCA model proposed by the committee for determination of the L1 vendor was approved by Secretary (Defence Finance), Defence Procurement Board (DPB) and the Defence Acquisition Council (DAC) for inclusion in the MMRCA RFP (for the first time) issued in August 2007. While considering the heavy-lift helicopter procurement case in February 2009, the DPB directed that all ‘applicable elements’ of the MMRCA TCA model may be used for all future aircraft procurements. This has become the norm since then.

While the TCA model was used for the first time in MMRCA RFP, the contract for procurement of basic training aircraft (BTA) was the first case to fructify using the TCA model. BTA case using the TCA model was accorded ‘no objection’ by the Ministry of Finance (MoF) and the Cabinet Committee on Security (CCS) approval in May 2012, thereby validating the TCA model. Based on the experience gained and suggestions of MoF, a proposal to include TCA model for all major weapon system procurements is being processed for inclusion in the DPP.

Elements of TCA

TCA includes direct cost of acquisition, cost of total technical life (TTL)-based reserves, cost of time between overhauls (TBO) mean time between failures (MTBF)-based reserves, cost of inspection level servicing, cost of repair level servicing and overhaul, basic operating costs and cost of transfer of technology (ToT). The types of spares include daily use spares such as consumables, line replaceable units (LRUs) and items like nuts, bolts, filters, fuses, etc. Intermediate level spares are used for rectification of the LRU up to card level. Depot level requires spares for major servicing and repairs. TTL and TBO-based reserves include components with specified life after which they need to be mandatorily replaced such as engine, pumps, gear boxes, cartridges, etc. If an aircraft has a TTL of 10,000 hours and engine TTL is 5,000 hours, two engines will be required in the life time.

MTBF-based reserves relate to items which are not lifted but will have to be replaced on failure. The MTBF provided by the vendor forms the basis for these reserves. Manufacturer recommended list of spares (MRLS) caters for scheduled and unscheduled servicing and maintenance for the first five years after induction. The vendor is bound by ‘adequacy of spares’ clause and a ‘buy back’ clause in case of under/over assessment of spares required.

The direct cost of acquisition includes aircraft, weapons, support and handling equipment, MRLS for five years, tools and testers up to intermediate level servicing, initial training of personnel, training aids and publications. Cost of TTL-based spares include all mandatory replacement items up to stipulated life. Cost of spares for intermediate level is included in the MRLS, so only man-hour cost has to be factored in. Cost of depot level servicing over the entire life includes man-hours and spares and the ammortised cost of infrastructure required to be set up at repair depot. The operating costs are essentially for fuel.

MMRCA TCA included seven elements. For all subsequent cases only five elements were involved as cost of MTBF-based reserves and cost of ToT were not applicable. MMRCA case is for 126 aircraft to be operated from five to six different locations requiring a large inventory of spares and reserves. MTBF-based reserves are low in all other cases as the numbers and locations are fewer and the platforms are less complex.

L1 Determination

For fair comparison, the cost of bids need to be brought to a common ‘date and currency’. As per DPP, all bids are to be compared as on the date of opening of the commercial bids. Therefore, for TCA, all costs are brought to their ‘net present value’ (NPV) as on the ‘bid opening day’. The vendor with the lowest NPV of TCA emerges as the L1. Since the RFP seeks a ‘firm and fixed’ cost, to calculate NPV, all the future cash flows for the entire contract period need to be ‘discounted’ to bring them to their ‘present value’ through the discounted cash flow (DCF) method. The prevalent ‘lending rate’ by Central and state governments is used as the ‘discounting rate’. Early payments will result in higher ‘present value’ in comparison to the same amount with delayed payment.

The vendors quote cost for a ‘base year’ (stated upfront in the RFP) along with an ‘indices based escalation formula’. These costs are ‘escalated’ to their ‘present value’, as on the ‘bid opening day’, using the escalation formulae. Similarly, cost of TTL-based reserve and ‘D’ level servicing is quoted for a base year and these are escalated to their ‘present value’, as on the ‘bid opening day’. Vendors only provide ‘man-hours’ for ‘I’ level servicing and its ‘present value’ is computed using the man-hour rate (MHR) prevalent in India on the bid opening date. The ‘fuel consumption’ is determined during the flight testing and the ‘present value’ of operating cost is computed using the ‘fuel rate’ prevalent in India on the bid opening date.

Hence, all elements of TCA are at their ‘present value’ as on the bid opening date. The vendor with the lowest NPV of TCA emerges as the L1. Direct acquisition costs are validated by the Technical Evaluation Committee and during flight and maintenance evaluation, and validated by CNC. Certified manuals, component log cards, servicing task cards are also studied. The contract includes all ‘specifications’ and ‘cost parameters’ quoted by the vendor. The contract also includes a specific clause stipulating that subsequent revenue contracts would be mutually finalised on the basis of these reference cost parameters and escalation formulae. To bind the vendor to the MTBF data provided by him, the contract includes a strong MTB- linked warranty for 10 years with a bond of five per cent the contract value.

TCA-based L1 determination will result in significant cost saving over the life of the aircraft. Besides binding the vendor to the DCA, as in the conventional model, the TCA model goes a step further to provide the cost parameters and specification of all elements with a strong MTBF-linked warranty. Thus, the TCA model provides a much better visibility and price discovery for future revenue contracts as compared to the conventional DCA model. TCA model will obviate situations wherein an aircraft inducted with low initial cost, has very high operating and maintenance expenditure. TCA model is a ‘scientific method’ of procurement decisions.

(with inputs from IAF Headquarters)