Total Cost of Ownership (TCO), sometimes Cost Driver Analysis, Acquisition Cost or Value for Money (VfM), is an estimate of the true cost of buying a product or service. It is the sum of all costs incurred during acquisition, possession, utilization and disposition of a product or service. TCO is important because it represents a bigger picture beyond the basic purchase price and reflects the costs that aren’t necessarily included in the upfront pricing.
Total Cost of Ownership aims to derive the actual cost of a product or service procured from a particular supplier. It’s a purchasing tool used for analyzing supplier offers and pricing from a broader business perspective to obtain the true cost of buying from that supplier. TCO can be applied to any type of purchase and is derived as a sum of initial purchase price, all direct expenses and all estimated indirect expenses.
There are usually three primary uses of TCO analysis:
- Supplier selection
- Evaluating supplier’s performance
- Driving major process changes
Neglecting TCO analysis can reduce efficacy of these processes and prove costly to the buying organization. It can likely result in poor decisions, thereby hurting the company’s overall competitiveness, profitability, pricing decisions and product mix strategies.
Benefits of a TCO Analysis
A careful and comprehensive TCO analysis can help the buying organization by:
- Helping decide between outsource/make/buy decisions.
- Imparting a long-term purchasing attitude that emphasizes the TCO rather than just purchase price;
- Allowing to justify higher initial prices based on higher quality or lower total costs in the long run;
- Offering excellent data for supplier negotiations;
- Working as a supplier evaluation tool and improving the value of supplier performance comparisons;
- Helping clarify and define supplier performance expectations;
- Identifying the areas in which supplier performance can create big opportunities for cost savings;
- Improving organization’s understanding of supplier performance issues and cost structure;
- Supporting strategic alliance efforts;
- Aiding in supply base reduction and/or volume allocation decisions;
- Concentrating resources on select important purchases.
Barriers to adoption of a TCO Analysis
While TCO analysis is indispensable to the buyer, there are several factors that complicate its adoption:
- Lack of activity-based costing in organizations can limit TCO’s widespread adoption. Unavailability of readily available accounting and costing data significantly undermines TCO’s reliability.
- Lack of a standardized approach to TCO analysis is another major barrier. TCO models vary from purchaser to purchaser, and even within the purchaser’s organization with respect to the items purchased.
- Costs used to calculate TCO are often situation-specific. The significance of a cost to the decision making process may vary with the nature and importance of the purchase.
- Adopting TCO requires a cultural change in the organization, wherein the focus has to shift from price to the total price in the long run.
Approaches to a TCO Analysis
There are generally considered two main approaches for determining TCO:
Cost-based Approach
This approach calls for allocating actual cost data for each of the relevant TCO items. Although it’s complicated to decide which items to include and gathering their costs, the results of this approach are relatively straightforward to explain and create a more accurate picture of the cost of doing business.
Value-based Approach
In this approach, both quantitative and qualitative elements make up the TCO. Using performance data that is difficult to measure makes the analysis rather complex, often requiring very lengthy explanations of each cost category. Unlike in dollar-based approach, TCO costs cannot be directly traced back to dollars spent in the past, currently being spent or estimated to be spent in future. Organizations choosing value based-approaches prefer it because when their priorities change, the ‘weightage’ of cost items can be changed accordingly.
Conclusion
Total Cost of Ownership (TCO) analysis provides an excellent means to supplier selection and evaluation. Apart from giving a true picture of actual cost of buying a product or service, TCO also presents valuable data set to measure the performance of the suppliers. It can also be used to identify issues in the ongoing operation that are adding to the total cost. The benefits of the TCO analysis justify the complications faced during its adoption, and buying organizations using TCO will have a competitive edge.
Key Takeaways
- Procurement professionals should develop and implement a TCO analysis using a planned process, assessing what TCO will be used for, and focusing on the benefits desired by the organization. As a minimum, TCO should be used for the most strategic and profit impacting purchases.
- After devising the customized TCO model, procurement professionals should ensure its adoption to the greatest extent possible. This will lead to consistency in internal and external communications relating to supplier selection and evaluation.
- A TCO analysis should be reviewed each 12 months for the most strategic activities to assure the original cost structure still remains and the decisions made are still relevant.