Total Cost of Ownership: Getting the Whole Picture

Indians have a reputation for being very prudent and astute buyers. And as an Indian I have experienced this first-hand several times, both, in a personal and professional capacity. A classic example of this is when an Indian goes to buy a car. Even before any negotiations take place, the first couple of questions directed at the salesman are, “How much mileage does this car give”? and “What is the annual maintenance cost”? What is happening here is that inadvertently, the buyer is trying to calculate/understand the overall cost of owning and operating this car over its useful life. And this, very simply put, is the concept of Total Cost of Ownership (TCO).

TCO, also known as Life Cycle Costing, involves calculating all the costs associated with owning and using a product/service over its expected life. Typically, most people make sourcing/purchasing decisions based on the Purchase Price only. This can lead to wrong decisions, especially when purchasing products/services that require recurring operating expenses also known as “Cost of Usage”.

Coming back to the car example, the Purchase Price that we pay for a car is only a part of the total cost of owning and operating that car. Typically, the purchase price ranges from 30% to 50% of the TCO. So, what are some of the main items that contribute to the other 50% to 70% of the cost? They include expenses such as fuel costs, interest payments, taxes, insurance, maintenance (scheduled and unscheduled including repairs) and miscellaneous expenses such as parking, tolls, tickets and fines, etc. Another big item is the loss in the resale value of the car. Even though this is not a cash outflow, it is a cost associated with owning the car. This is what we call an Opportunity Cost. More on this in a bit.

As stated above, when we build a TCO model, we calculate the present value of all the costs associated with owning and using a product or service over its expected life. All the costs can be classified in to one of the following 4 buckets:

 

Typically, TCO analysis should be done anytime an Organization is buying capital assets such as equipment, machinery, vehicles, etc. In order to ensure that we make the right sourcing decision, it is critical that we understand the overall financial impact of the decision. If we make our decision purely based on the Purchase Price, we could end up making a very wrong decision that could cost the company a lot more money in the long-term. Let’s look at an example to illustrate this point:  

Let’s say your company wants to buy an equipment with a life of 10 years. You are currently evaluating 2 potential suppliers, Supplier A and Supplier B. Supplier A has quoted a price of $6 million for the equipment, while Supplier B has quoted $4 million. If we were to just look at the Purchase Price, we would probably pick Supplier B because they are $2 million cheaper than Supplier A, representing a 33% savings. However, if you are provided the additional information below, would it change your decision:

Usage Cost per Year

Supplier A

Supplier B

Fuel

$600,000

$1,000,000

Maintenance – Scheduled

$200,000

$500,000

Maintenance – Unscheduled

$200,000

$500,000

Total Usage Cost per Year

$1,000,000

$2,000,000

 

If we buy the equipment from Supplier A, we will save $1 million per year on fuel and maintenance cost. Over a period of 10 years, this amounts to a savings of $10 million. Using a cost of capital of 9%, the present value of these future savings is approximately $6.4 million. Now, which Supplier looks better? If we were to buy the equipment from Supplier A, we will save an additional $4.4 million (after deducting the extra $2 million paid towards the purchase price) over the 10-year life of the asset. This is where smart equipment manufacturers make money off their customers. They are willing to give big discounts upfront on the Purchase Price and then make huge profits on the after sales service including the spare parts. A classic example of this strategy is the desktop printers. Printer manufacturers are happy to give the printers for free because they know that the real money is in the ink cartridges!!!

A few years ago, we did a TCO analysis for a major Oil & Gas company that was conducting a sourcing exercise for the procurement of Gas Turbines. Typically, the life of these turbines is around 15 to 20 years. What we found was very interesting. The Purchase Price was less than 10% of the TCO, while the Usage Cost represented more than 90% of the TCO. Within the usage cost, the 2 biggest items where fuel cost and cost of maintenance and spares. In such a scenario, what should be the driver of your sourcing decision – reduction in purchase price or selecting the supplier with the most efficient Usage Cost? Seems like a no brainer, doesn’t it?

As stated earlier, when we do a TCO analysis, we capture not only the cash costs/outflows, but also the opportunity costs. In some cases, the Opportunity Cost can be the deciding factor in selecting the right sourcing option. So, what is Opportunity Cost and how do we calculate it.

Opportunity Cost is the value of a lost benefit resulting from a certain action/decision. Some typical examples of Opportunity Cost are lost production/revenue due to late delivery, due to inefficient operations, due to equipment downtime for repairs/maintenance, etc.  

How do we calculate Opportunity Cost? It is calculated as the lost contribution from one unit of sales/production multiplied by the number of units lost due to a missed or lost opportunity. Sounds confusing? Let me illustrate how to calculate Opportunity Cost using the example of the equipment Suppliers A and B above:

 

Supplier A

Supplier B

Delivery Lead Time

60 days

100 days

Daily production (units)

12,000

15,000

Annual production (units)

4,380,000

5,475,000

Contribution per Unit

$40

$40

 

Opportunity Cost of Late Delivery – If we buy the equipment from Supplier B, we must wait an additional 40 days extra for delivery compared to Supplier A. During these 40 days, we lose out on potential production of 480,000 units (40 days * 12,000 units per day). Therefore, the opportunity cost of lost production due to late delivery is $19.2 million (480,000 units * $40 per unit). This is a one-time opportunity cost

Opportunity Cost of Lost Production – If we buy the equipment from Supplier A, while we get delivery earlier, we will produce 1,095,000 units fewer per year (5,475,000 – 4,380,000) compared to Supplier B’s equipment. Therefore, the opportunity cost of lost production is $43.8 million per year (1,095,000 units * $40 per unit). This is a recurring opportunity cost over the life of the equipment.

Based on the above analysis, Supplier B now appears to be the logical choice. However, please keep in mind that, for the sake of simplicity, we have made a very important assumption in the above analysis –we are assuming that we can sell every additional unit that we produce.

In conclusion, TCO is a very powerful tool and is typically used at the time of making Sourcing decisions as it “forces” the user to examine the overall financial impact of sourcing options and thereby helps the user make the “right” sourcing decision. It encourages companies to become more long-term and strategic in their decision making process rather than short-term and tactical.

For more information, services or training programs on Total Cost of Ownership, kindly visit our website  www.anklesaria.com . For more exciting cost management and procurement related news and updates, be sure to follow us on Linkedin @ The Anklesaria Group

 

 


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