Total Cost of Ownership

Total Cost of Ownership (TCO) is defined as a philosophy for developing an understanding of all relevant supply chain related costs of a particular transaction or process. TCO considers total cost of acquisition, use/administration, maintenance, and disposal of a given item or service.

How Does TCO Compare to Other Approaches? Price!
TCO from a supplier's perspective: From produce to delivery, there are labor, packaging, raw materials, overhead, and transportation.

TCO from a buyer's perspective: It includes purchase price, transportation, duties, and on-time delivery. Other challenging issues such as the cost of failures working with suppliers and further required education, training, and administrative support.

Why the Interest in TCO?
Besides Reduction of TCO becomes the main concern to establish Strategic Alliances, other reasons facilitate TCO as the key model include Advanced Information Systems, Reduction of Supply Base, Outsourcing, Development of Activity-Based Cost Management (ABCM), Discovery of "Hidden" Cost Drivers Discovery, and the Increasing Importance of Supply Chain Management.

Choosing a Project for TCO Analysis
TCO does not fit to every purchase or process analysis. However, in order to pursue early success, as following list is a good initiative approach to start a TCO project.

Characteristics of Item for Pilot TCO Project (*Source: See below, References & Readings)
1. The firm spends a relatively large amount of money on that item.
2. The firmpur chases the itemwith some degree of regularity, in order to provide some historical data, but more importantly, to allow opportunities to gather current cost data.
3. Purchasing believes the itemhas significant transaction costs associated with it that are not currently recognized.
4. Purchasing believes that one or more of the currently unrecognized transaction costs are individually significant.
5. Purchasing has the opportunity to have an impact on transactions costs, via negotiation, changing suppliers, or improving internal operations.
6. Those purchasing/using the item will cooperate in data gathering to learn more about the item’s cost structure.

Types of TCO Analysis
Two general approaches to perform TCO analysis: A One-Time Project Analysis or a Computerized, Ongoing System.

One-Time Project Analysis is primarily customized and used to support a specific decision-making situation, e.g. Outsourcing, Reducing Supply Base, Forming Alliances, Looking for Areas for Improvement/Cost Drivers, and Selecting key Suppliers.

On the other hand, less common Computerized System is ideal for analyzing repeating purchases, e.g. raw materials, packaging, MRO, and supplies. This ongoing system is used to Allocate Volume among Suppliers, Provide Suppliers Feedback, Focus on Areas for Improvement/Cost Drivers, and Cost Products/Services. However, this automated TCO approach works best while tied to ABCM system.

Getting Started
1. Identify a promising project for TCO analysis
2. Team setting, cross-functional and/or cross-company team (e.g. purchasing, finance/accounting, users, key stakeholders, and any functional/technical experts)
3. Keep a reasonable scope of TCO analysis (benefit exceeds costs of Pre-Transaction, Transaction, and Post-Transaction)
4. Perform sensitivity analysis to determine relevant costs

Major Categories for the Components of TCO (*Source: See below, References & Readings)
1. Pre-Transaction: Identify need, Investigate sources, Qualify sources, Adding suppliers to internal systems, Education, and Contract process
2. Transaction: Price, Order placement, Delivery, Duties, Payment, Inspection, Returns of parts, and Follow-up & correction
3. Post-Transaction: Line fallout, Defective finished goods rejected before sales, Field failures, Repair/replacement in field, Cost of repair parts, Cost of maintenance & repairs, Cost of disposal, and Disposal

Implementation Issues
1. Demonstrate TCO philosophy as a superior way to manage and understand costs, (e.g. a successful TCO pilot project)
2. Based on TCO components, expend efforts on: Process flowchart, Determine significant cost components, Determine calculating & monitoring method, Compile cost component data, and Analyze the results
3. Identify where to start its TCO effort
4. Determine how and where to implement TCO in the organization

Continuously Improving TCO
TCO projects should be reanalyzed and audited continuously, e.g. 6 months to a year. Nevertheless, it is also essential to increase TCO's visibility and recognition in the organization by monitoring and reporting TCO project results.

Level of TCO Analysis:
Strategic: improve process, Tactical: work on supplier improvement, and Operational: manage and measure suppliers

Excerpt from: The Purchasing Handbook - A Guide for the Purchasing and Supply Professional


References & Readings:

Carr, L. P., and C. D. Ittner. ‘‘Measuring the Cost of Ownership.’’ Journal of Cost Management, Fall 1992, pp. 42–51.
Cavinato, J. L., ‘‘A Total Cost/Value Model for Supply Chain Competitiveness.’’ Journal of Business Logistics, vol. 13, no. 2, 1992, pp. 285–301.
L. M. Ellram, ‘‘A Framework for Total Cost of Ownership,’’ International Journal of Logistics Management, vol. 4, no. 2, 1993, pp. 49–60.
L. M. Ellram, ‘‘A Structured Method for Applying Purchasing Cost Management Tools,’’ International Journal of Purchasing and Materials Management, vol. 32, no. 1, 1996, pp. 20–28.
L. M. Ellram, ‘‘Activity Based Costing: An Opportunity for Purchasing Improvement,’’ In A Changing Environment: 80th Annual International Purchasing Conference Proceedings, NAPM, Tempe, Ariz., 1995, pp. 1–5.
L. M. Ellram, ‘‘Activity Based Costing and Total Cost of Ownership: A Critical Linkage.’’Journal of Cost Management, Winter 1995, pp. 22–30.
L. M. Ellram, "Total Cost Modeling in Purchasing," Center for Advanced Purchasing Studies, Tempe, Arizona, 1994.
L. M. Ellram, ‘‘Total Cost of Ownership.’’ In D. Hahn and L. Kaufmann, ed., Handbuch Industrielles Beschaffungsmanagement, Gabler, Wiesbaden, 1999.
L. M. Ellram, ‘‘Total Cost of Ownership: An Analysis Approach for Purchasing.’’ International Journal of Physical Distribution and Logistics Management, vol. 25, no. 8, 1995, pp. 4–20.
L. M. Ellram, ‘‘Total Cost of Ownership: Elements and Implementation.’’ International Journal of Purchasing and Materials Management, vol. 29, no. 4, 1993, pp. 3–11.
L. M. Ellram and A. Maltz, ‘‘The Use of Total Cost of Ownership Concepts to Model the Outsourcing Decision,’’ International Journal of Logistics Management, vol. 6, no. 2, 1995, pp. 55–66.
L. M. Ellram and O. R. V. Edis, ‘‘A Case Study of Successful Partnering Implementation,’’ International Journal of Purchasing and Materials Management, vol. 32, no. 4, Fall 1996, pp. 20–28.
L. M. Ellram and S. P. Siferd, ‘‘Total Cost of Ownership: A Key Concept in Strategic Cost Management Decisions,’’ Journal of Business Logistics, vol. 19, no. 1, 1998, pp. 55–84.
Maltz, A., and Ellram, L. M., ‘‘Total Cost of Relationship: An Analytical Framework for the Logistics Outsourcing Decision.’’ Journal of Business Logistics, vol. 17, no. 1, 1997.
P. Bennett, ‘‘ABM and the Procurement Cost Model,’’ Management Accounting, March 1996, pp. 28–32.
T. Hendrick and L. M. Ellram, Strategic Supplier Partnerships: An International Study, Center for Advanced Purchasing Studies, Tempe, Arizona, 1993.