What is Total Cost of Ownership?
Total Cost of Ownership (TCO) is a concept used in procurement and supply chain management to understand the complete cost of a product or service over its entire lifecycle. TCO takes into account all costs associated with acquiring, owning, and disposing of a product or service, including both direct and indirect costs.
In evaluating the price of an item, procurement managers should consider the impact of the purchase on the entire manufacturing value chain. For example, there could be several costs associated with the procured item in converting it into a finished product.
These costs may vary for all the suppliers from whom the item is purchased. For example, a supplier may quote a lesser price than his competitors, but it may turn out that some hidden costs are involved. Maybe the item requires some additional processing, making the overall cost higher, compared to other suppliers.
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Or, maybe the set-up involved in manufacturing takes a long time for items purchased from a particular supplier, or maybe it requires additional inventory-carrying costs or quality costs due to special requirements. It is also possible that disposal of the waste associated with the item costs more when procured from a particular supplier.
In practice, there are several costs associated with the procured item in all three phases of its life cycle: acquisition, ownership, and post-ownership. Researchers say that if all these costs are considered, the proportion of quoted price on overall costs could be less than 50% of the overall costs involved.
Thus, it becomes necessary to study the overall costs involved in acquiring an item instead of focusing on the quoted price alone. Such an analysis is called Total Cost of Ownership (TCO) analysis. This concept, though initially evolved to address several costs associated with the purchase of capital equipment (that are meant to serve over many years), has become a strategic tool in supplier evaluation and cost management of all types of procured items.
There are several costs associated with an inventoried item before it becomes part of the finished product and reaches the end user. For example, for an inventoried item procured, there are several costs incurred as it goes through several phases of the manufacturing value chain.
It starts with the cost of transportation and shifting to the warehouse location. Then, there are costs associated with storing the procured item appropriately in stores till drawn for usage at the manufacturing plant.
Once sent to the manufacturing floor, there are costs associated with the conversion process starting with manufacturing set-ups required, other associated items required for the conversion process, the method of using the item in the manufacturing process, downtime costs associated with the item, energy requirement of the item, MRO items required and similar conversion-related costs.
Once the procured item is used in the manufacturing process and the finished product is produced, there are costs associated with the post-ownership phase that ends with the disposal of any waste associated with the item. If all these costs incurred at each of these phases are going to be the same irrespective of the supplier from whom the item is purchased, only the initial item price will matter during supplier selection.
However, it is quite possible that depending on the nature of both the item and the supplier, the associated costs could be different – this happens normally for most non-standard items for which prices are not determined by market forces alone.
An item purchased from a low-cost supplier may incur more costs during the later phases when compared to the same item purchased from another supplier. Hence, it becomes necessary for the procurement manager to consider the TCO of items instead of just the price alone.
The price may constitute a low percentage of TCO (as low as just 10% of the overall cost of ownership), depending on the nature of the item. Hence, a purchase decision should not be made on the basis of a factor that accounts for only, say, a 10% contribution, to overall costs.
This is the basic philosophy behind the TCO concept. The TCO principle requires a procurement manager to identify and measure every cost associated with the procured item when comparing prices quoted by different suppliers. Thus, it can be defined as the present value of all costs associated with a product, service, or capital equipment that are incurred during its life cycle.
The TCO concept was initially used widely for the procurement of capital equipment, which have several post-procurement costs involved with them, and which are also irrevocable long-term high-value choices.
With the advent of the strategic cost management concept, as mentioned before, the TCO concept is now widely employed even for procuring critically inventoried items used in normal manufacturing processes.
Total Cost of Ownership Categories
TCO costs can be categorized into the following types:
These costs include the purchase price of the item and all costs associated with bringing the item to the manufacturing location. It includes shipping and logistics costs, inspection and quality-related costs, freight, and taxes, administrative costs, etc.
Ownership costs are incurred after the item has been acquired. This includes all costs associated with converting the item into the finished product and supporting it throughout its usable life, viz., operation costs, conversion costs, downtime costs, risk management costs, non-value-added costs, supply chain costs, Annual Maintenance contracts (AMC), etc.
Some important types of ownership costs are storage costs, inventory carrying costs, installation costs, conversion costs, costs involved in the scrap, warranty costs, and opportunity costs associated with the usage of the item.
These costs include costs incurred after the product reaches the end of its usable life. Examples of such costs are disposal costs, environmental costs, product liability costs, salvage value, etc.
Steps in Obtaining TCO for Procured Item
The steps involved in obtaining TCO for a procured item are as follows:
- Document the P2P process involving the item being procured.
- Identify the various activities associated with each of these processes related to the item.
- Determine cost elements associated with these activities.
- Identify the associated cost measurement metrics.
- Collect data associated with the cost and quantify costs across the life-cycle of the usage of the item,
- Develop a cost timeline. This means identifying the time at which costs are incurred. For example, in the case of capital equipment, any salvage value associated with the scrap may happen many years later, which cannot be treated in the same line as that of initial acquisition costs.
- Calculate the present value of all costs involved. This involves discounting future costs with an appropriate discount rate (usually company cost of capital).
- Calculate the sum of all present values to determine the cost applicably today. This will be the TCO of the item.
- Perform TCO analysis for each supplier and select the supplier who provides the lowest TCO.
How is Total Cost of Ownership Calculated
Let us now look at some illustrations to understand how TCO is calculated for supplier evaluation:
The procurement manager of ABC Automobiles is evaluating two suppliers for a long-term supply contract applicable for the next year. Supplier A is quoting a price of $300 per batch as against Supplier B who quotes $230. Both of them are reputed suppliers for quality and service.
Supplier A is a major tier-1 supplier and offers a VMI program in lieu of the higher price quoted by him. He claims that owing to the management of inventory by the supplier himself, there will be great cost savings involved which will offset the lower price quoted by the competitor. ABC Automobiles normally order 1,500 batches during a year.
Related data pertaining to acquisition and ownership are given below. Assume all other costs (for example, conversion or disposal, related costs are the same for both the suppliers being a standard and identical product being offered)
Number of POs/Invoices that will be eliminated due to VMI = 1500
Processing cost per PO/Invoice = $20
Overhead costs associated with warehousing and inventory = $50,000
Labor costs associated with warehousing = $60,000
You can perform supplier evaluation using the TCO concept that takes into account costs beyond the prices of items being procured.
TCO = Acquisition Costs + Ownership Costs + Post-Ownership Costs
Note that when analyzing TCO for supplier evaluation, we need to consider the difference between the costs of the two suppliers.
Since conversion and post-ownership costs are considered to be the same for both suppliers (because the item is standard and identical for both suppliers), we need to consider only acquisition costs for this problem.
Acquisition Costs = Price + Administrative costs + Warehousing costs
(Ignore other acquisition costs as they are the same for both suppliers)
Administrative costs = Procurement Processing Costs × Number of POs
= $(20 × 1,500)
Warehousing Costs = Warehousing Labour costs + Overhead Costs
= $ 60,000 + $ 50,000
= $ 110,000
Total Acquisition Costs = $(30,000 + 110,000) = $140,000
Total Cost of Ownership for Supplier B = Price × Quantity + Acquisition costs
= $(230 × 1500 + 140,000)
= $(345,000 + 140,000)
TCO for Supplier B = $ 485,000
Total Cost of Ownership for Supplier A = Price × Quantity + Acquisition Costs
= $(300 × 1500 + 0)
(Since acquisition costs are zero due to the VMI program)
TCO for Supplier A = $450,000
Since TCO for supplier A is less at $ 450,000 as against the TCO of supplier B at $485,000, supplier A is the cost-effective choice. The procurement manager should now focus on evaluating the capability and commitment of supplier A to manage the VMI program.