What is a Total Cost of Ownership (TCO)
In procurement, the Total Cost of Ownership (TCO) is defined as the sum of all costs associated with a product or service throughout its entire lifecycle, taking into consideration its direct costs and indirect costs, also called tangible and intangible costs.
The idea behind the TCO concept is to have a thorough consideration of all the costs. This can best be illustrated by an iceberg.
The purchase price of the goods is usually only the tip of the visible iceberg while the remaining costs which are not easily observed can represent 80% of the total costs. This concept is very important as most people that are not experienced or trained in procurement will only see the visible part. You can read more about the 20/80 rule here
What elements to consider in a Total Cost of Ownership (TCO) analysis ?
Costs can be divided into 3 big categories and each category is made of different costs. Here are below the costs that you need to take into consideration.
Landed costs
- Purchase price: includes the cost of the product or service and the supplier margin
- Transportation cost: the cost to transport the goods from the supplier’s factory to its destination, it can be a mixture of various means of transport when it comes to international trade, this is called intermodal transport. The 3 main types of transportation are by sea, by air, and by land. Each has its own advantages and inconveniences.
- Packaging cost: the cost to protect your goods during the shipment. Carton box, shrink wraps, bubble wraps, etc. This is impacted by the following factors: weight, size, shape (towability), handling, urgency and distance .
- Custom duties: this includes VAT, tariffs, custom duties, various taxes, handling fees, etc.
- Acquisition and administrative cost: this is the cost related to the clerical activities such as billing, payment, invoicing, running the procurement operations
- Inventory cost also called ownership cost: This is the cost of carrying, ordering, and managing the stock, including inventory depreciation over time.
Process Change costs
- Requirements definition and market research: Complex products and services can require a considerable amount of time to define the specifications. Market research requires extensive work from the team: identify various potential sources of supply, analyze offerings as there are multiple solutions for any needs (think transportation, by air, by road, by train?), gather knowledge about the market and trends, paying for specialized publications or using consultancy services, etc.
- Product development: Developing products in-house got a cost, from R&D, designing the product, engineering team involved, and other overhead costs. Procuring complex products or services from external suppliers also got product development costs, we often talk about co-development when companies partner with suppliers to share common resources
- Contract sourcing: There are a lot of costly activities involved when partnering with a supplier. Searching for suppliers may require third party solutions or marketplace subscription or simply time which is money. Selection involves many departments’ resources, it may also be worth using an e-auctions platform for example. Qualification often requires physical audit, it may be worth having a budget for air fares, hotel and transportation costs. Legal review can be fairly time consuming, for very complicated contracts, it may be needed to consult external experts.
- Change management and training: transformation programs can be very costly. Take the example of deploying a new ERP system, it takes huge planning effort, hours of meetings, presentations to obtain buy-in, then workshops, UAT with stakeholders, training sessions for key-users and end-users, time to draft manual and map processes, and extensive support after the roll-out to ensure a smooth transition. All these costs money. It’s not always easy to estimate but time and resources are not free.
- Factory openings/closings, suppliers on-boarding/termination: Switching suppliers or service providers is not always an easy task as simple as flicking a switch. Things that need to be considered are early termination fees, knowledge transfer, data transfer, disruption to your supply chain, contractual commitment that you may have, etc. On-boarding new suppliers has also its own set of challenges and costs.
- Supplier ramp-up and integration: Cooperation with new suppliers takes time, effort and dedication to ensure that both parties’ expectations are met. During the ramp-up and integration phase, audits, workshops, training, setting up electronic data interchange (EDI), and systems integration between companies are needed and it costs money. This is important to consider when comparing existing suppliers which wouldn’t incur such costs with new suppliers.
Ongoing costs
- Life cycle cost: what is the quality of the product, how durable it is, and how easy is it to maintain ? Some products may be very cheap but not durable and impossible to replace internal components.
- Maintenance, repair, and operations (MRO) costs: machines need lubricants, spare parts, tooling replacement, etc. MRO can represent significant spending for procurement. Read more about MRO here
- Cost of Quality: does the product come with warranty ? for how long and what does it include ? Not all warranties are equal, some will only cover material to be defect free, others will cover workmanship as well such as errors from contractors during installation. Other elements that need to be considered would be whether suppliers provide free of charge return in case of insatisfaction, and replacement.
- Environmental cost: sustainability is at the heart of many company’s preoccupations in recent years, and there is a cost associated with sustainability. Procurement needs to ask themselves the following questions: what is the cost of recycling, recovering materials, and disposing end-of-life products. How much will it cost to organize the reverse-logistics ? Read more about environmental cost here.
- Reputation cost: It takes years to build a reputation and an instant to destroy it. For example, automotive companies rely heavily on suppliers for their components, but whenever there is a recall due to safety concerns, it’s always the automotive company that is to be blamed in the public opinion. Procurement professionals are advised to keep in mind potential reputation cost when selecting a supplier. Cheap is not always best
How to use a Total Cost of Ownership analysis as a decision-making tool ?
- Start with creating a task-force that will work on the Total Cost of Ownership categories definition. e.g. set-up a task force to procure a new leaflet folding machine
- Estimate the costs for each category by using the information provided by the supplier, historical data, or using estimate techniques like triangular distribution and PERT. For more information, read our article on estimation here. e.g. purchase price of the machine quoted by the supplier, electricity cost, spare parts costs,
- Define the unit of measure and quantity needed for each cost category when relevant. Some costs are “one-time” cost such as custom duties, e.g. electricity consumption per hour provided by the manufacturer, usage of the machine per day estimated by the production department, volume of lubricant needed, etc.
- Calculate the cost by multiplying the quantity by the standard cost previously identified for each category. e.g. xyz kw/h*consumption per hour*period of time
- Establish the estimated lifetime usage of the product or service, and use previously calculated cost to now calculate total cost for the lifetime period..
- The total cost for the lifetime period should now be brought back to “present value”.
Conclusion
Estimating all those costs is not an easy task and it should only be done for strategic procurement initiatives with big potential impact. It is not always possible to estimate precisely everything, but an estimate based on assumptions is always better than no estimate.
Some companies would prefer using the simpler version Total Landed Cost which is the sum of all the landed costs. The main advantage is of course a quicker analysis, however you will lose sight of some other costs perspective that may amount to considerable money. For example, the procurement of tailor-made equipment can have huge maintenance, repair, and operation costs.
TCO or TLC, what matters is to be aware that the purchasing price is usually a fraction of the total costs, and that it is very important to have in mind that other costs can amount to substantial money. So next time your internal client tells you to purchase a product with a cheap price tag, make sure to show them the picture of the iceberg.
Download our free TCO spreadsheet template here !