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**Life Cycle Cost Analysis in Pavement Design - In Search of Better Investment Decisions -**

Executive Session Office of Asset Management Federal Highway Administration 2

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**Introduction Who are we Why are we here: Why are we doing that:**

Jim Walls - Eastern Resource Center Keith Herbold - Midwestern Resource Center Tom Canick – Office of Asset Management Why are we here: To deliver FHWA’s LCCA probabilistic software workshop Why are we doing that: FHWA supports application of LCCA in pavement decisions Continuation of our prior efforts 3

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**Presentation Agenda Probabilistic Approach RealCost Software**

Workshop Overview Probabilistic Approach RealCost Software Why Use LCCA Management’s Role 3

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**1. Workshop Overview Software instruction Class exercises LCCA review**

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**Workshop Overview LCCA Review LCCA Process Components and Issues**

User Costs Probability and Risk Input Recommendations 3

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**FHWA LCCA Methodology Steps Establish Design Alternatives**

Determine Activity Timing Estimate Agency and User Costs Compute Life-Cycle Costs Analyze the Results These are the steps to performing an LCCA, which will answer the question: “What materials and methods are we going to select to fulfill the objectives?” I will go through them in order, detailing some of the effort required at each point We will revisit these steps again and again in this course and will refer back to the material presented here.

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Workshop Overview Software Capabilities How to use Demonstration 3

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**Workshop Overview Hands-on Software Exercises Class Exercises**

Interpreting Results 3

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**2. Probabilistic LCCA What is it What does it add to the process**

How to interpret it 6

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**Probabilistic Approach**

Captures the uncertainty in the inputs, Carries that uncertainty through the computation process to generate a Probability distribution of result (a range of possible outcomes along with their likely hood of occurrence). Probabilistic LCCA treats inputs as ranges of possible values and assigns a likelihood of occurrence to those values. Just like deterministic inputs, probabilistic inputs are based upon historical data, expert opinion, and research. Probabilistic analysis allows for simultaneous variability among inputs. Probabilistic outputs are also ranges of values with calculated likelihood of occurrence.

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**Probabilistic versus Deterministic Approach**

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**Deterministic Approach**

Inputs are discrete or point values Initial costs are $11M The discount rate is 4% Outputs are discrete Alternative “A” total cost = $20.5M Alternative “B” total cost = $26.0M So far, for the purposes of example, we’ve treated inputs and outputs as specific values. Another way of saying this is that we’ve been looking at LCCA as a deterministic process with fixed, discrete inputs and outputs. Deterministic inputs are based upon historical data, expert opinion, and research. Input data are most likely or expected values. The calculations may be done with pencil, paper and a calculator or on a spreadsheet. A single (or discrete), deterministic output results from these most likely input values.

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**Deterministic Limitations**

Doesn’t Address: Statistical Significance Variability Subject to Manipulation Lacks Credibility 14

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**LCCA Results Deterministic Approach Probabilistic Approach**

Project cost estimate is $12 million Probabilistic Approach 75 percent chance the project will cost $12 million or less.

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**Simulation Modeling $ % Inputs Results M O D E L Net Present Value**

Animated Slide The LCCA outputs are a function of several inputs, such as agency costs, user costs and discount rates, which we believe all may vary independently. Probabilistic analysis results are obtained by using simulation software. Probabilistic analysis allows for simultaneous variation of inputs. An entire probability distribution of LCCs is generated for the project alternative along with the mean or average LCC for that alternative. By including all possible values for the analysis inputs in relation to their probability of occurrence, risk analysis elevates the LCCA debate from contesting the validity of results to deciding best public policy. %

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**Role of Probability in LCCA**

Accounting for variability in inputs: Activity timing, costs, discount rate Quantitatively determines risk in alternative strategy selection Elevates the decision from questioning the inputs to discussing the merits of each alternative Probability, statistics, and risk are used at several points in the probabilistic LCCA process. When collecting data for an LCCA we find that our data has variability: It is easier to correctly predict a range of values than a single correct value. Probabilistic life-cycle costs are calculated using simulation programming. Analysis of the simulation results can describe the variability in the LCCA. However, in order to make and support decisions using probabilistic LCCA, you must understand statistical risk analysis.

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Agency NPV B A Frequency Net Present Value

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**Advantages More Informed Decisions Evaluate all possible outcomes**

Expose areas of uncertainty...Quantify risk Determine significance of difference between alternatives Examine influence of underlying variables on final results Provide those vested with appropriate authority the opportunity to make decisions about risk taking 23

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3. RealCost Software 3

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**Benefits of Software Performs LCCA as per FHWA best practice**

Requires same data inputs as manual process Better, faster & cheaper analysis Automates user cost process 6

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Software Data Input

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Software Data Input

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Software Outputs

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Software Outputs

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4. Why Use LCCA Requirements FHWA’s Philosophy Benefits of LCCA 3

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**LCCA Requirements NHS Designation Act (1995) TEA-21 (1998)**

Required States to conduct LCCA of each NHS high cost ($25M or more) useable project segment. TEA-21 (1998) Eliminated this requirement. 4

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**FHWA Philosophy LCCA: Decision support tool Results are not decisions**

Rigorous analytical process can be as important as the results 6

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**Benefits of LCCA Improved rehabilitation strategies**

Better information for decisions Improved rehabilitation strategies Consideration of user costs Support for overcoming the “first cost” limitations 6

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**FHWA LCCA Guidance LCCA RealCost LCCA Technical LCCA Software**

Primer Bulletin Advanced DP Workshop Automated Slide, click mouse to highlight each word. Here is a definition of LCCA. Let’s review point by point: You have already determined that the project merits being done – you just don’t know how, yet. Analytical tool – LCCA is a structured method with specific steps to follow, inputs to include, and “rules” (that must be obeyed in order to get some useful and usable outputs). Cost comparison – LCCA includes initial costs, future costs, agency costs, and, in best practice, user costs. Competing design alternatives – Different ways to design, construct, maintain traffic around a single project. Equivalent benefits – each alternative being considered will produce the same benefit. The project – LCCA is used within the confines of one project where the alternatives provide different ways of accomplishing the same project.

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5. Management’s Role Management Support for Development and Application of LCCA. Develop LCCA Guidelines including Recommendations on Input Values 3

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Management Support Requires “buy-in” of risk management by senior executives Technical Champion Top management support 24

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**Developing Guidelines**

Analysis Periods Type of Dollars…Treatment of Inflation Type and Value of Discount Rates Treatment of User Cost Value assigned to user delay time Choice of Economic indicator Remaining service Life Ignore Sunk Cost 10

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**Developing Guidelines**

Analysis Periods Type of Dollars…Treatment of Inflation Type and Value of Discount Rates Treatment of User Cost Value assigned to user delay time Choice of Economic indicator Remaining service Life Ignore Sunk Cost 10

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**Developing Guidelines**

Discounting … a mechanism for quantifying the time value of money FHWA Recommends Real dollars and a real discount rate - do not account for inflation A real discount rate range of 3% to 5% Never mix real and nominal (inflation adjusted) costs and discount rate LCCA discounts an alternative’s future costs to their present value in order that they may be compared on the same basis to the present value of the costs of other alternatives. When estimating future cost for an LCCA, it is simplest to develop those costs in real (or constant) dollars. Real dollars do not include an inflation component. For example, the same material and labor costs used to price an activity in the base year of the analysis should be used to value them in any future year of the analysis ($40/ton of hot mix this year and 20 years from now). LCCA should use a discount rate that reflects the opportunity value of time, rather than one that includes an inflation component. Inflation is too difficult and complex to forecast. The discount rate should reflect historical trends. Long term rates, as reflected by nominal interest rates less inflation, are around 4%, and range from 3% to 5%. Public sector projects should be evaluated only on real gains (cost savings or expanded output), rather than purely price effects. Also, if you include an inflation factor in the costs/prices, you must also include one in the discount rate, effectively negating the use of inflation. Don’t mix real and nominal costs or discount rate.

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**Developing Guidelines**

User Costs are calculated through a capacity analysis. Observations: Traffic grows over time Queuing cost dominate Hourly distributions key $ Value of time has a major influence Normal VOC between alternatives negligible Probabilistic LCCA treats inputs as ranges of possible values and assigns a likelihood of occurrence to those values. Just like deterministic inputs, probabilistic inputs are based upon historical data, expert opinion, and research. Probabilistic analysis allows for simultaneous variability among inputs. Probabilistic outputs are also ranges of values with calculated likelihood of occurrence.

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**Developing Guidelines**

Value of Time Recommendations... Passenger Vehicle $10 - $13 Single Unit Truck $17 - $19 Combo Truck $21 - $24 1996 Dollars 13

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**Things to Remember NHS LCCA Requirements Document Inputs**

LCCA Decision Support Tool NHS LCCA Requirements Document Inputs Dispose of all Issues Provide Confidence Information 9

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The End That’s All Folks!

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Inputs are defined by probability distributions (their range of values and likelihoods of occurrence) Outputs are expressed as ranges of values with probability of occurrence

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