Why Managing Total Cost of Ownership Is So Critical
It can be said that the main role of Procurement is to help fulfil the enterprise’s strategic mission through its procurement activities in order to facilitate the organisation’s overall success in the market place. To this end, Procurement has to focus on the following four broad organisational objectives, i.e.:
- Sustaining the organisational mission (purpose), which is the reason why the organisation exists in the first instance;
- Supporting operational requirements, those both considered core as well as non-core requirements;
- Managing the procurement process and supplier base in as most effective and efficient manner possible; and
- Developing strong relationships with both the supply base as well as other internal functional groups.
In the context of these four objectives, it is not immediately evident that the temporal aspects of procurement play such a significant role however, and one may be tempted to solely adopt a short-term outlook as opposed to managing total life-cycle costs.
Defining Total Cost of Ownership
Considering a definition of what TCO is, we can say that managing Total Cost of Ownership is about managing all the costs associated with acquisition, transport, warehousing, carrying of inventory, deployment, operation, support, maintenance and final disposal, retirement or rehabilitation of a commodity (i.e. goods, materials or services). Gartner defines TCO as the “holistic view of costs across enterprise boundaries over time”, which brings in the temporal nature of costs to book. For purposes of this article then, and without losing the nuances of the aforementioned definitions, we’ll distil the definition to mean ‘the management of total costs of a commodity (goods, materials or services) over its life cycle’.
The previous paragraph indicates two critical aspects of TCO namely that: (i) the total cost an organisation experiences with the purchase of any commodity comprises a number of components, and (ii) those costs are incurred over time in different areas. We can further deduce that:
- Each cost component will impact TCO in different ways depending on the underlying cost drivers;
- The relative impact of each cost component varies depending on the nature of the commodity being procured;
- The relative weight of each cost component depends upon the assessment of the TCO impact on the business in respect of the commodity’s application;
TCO is therefore principally one of the most important pillars in Supply Chain Management because its aim is to identify, quantify and measure costs over time. In so doing, it expands the narrow confines of the Ex-Works item price, to a universe of opportunities for attaining cost sustainability in the supply chain. Simply put, anyone of reasonable capability can get the cheapest price for something, but the objective of Leading Procurement Practices is to attain the lowest TCO over a commodity’s life cycle.
Keeping It Real
Think of that second hand car sales person you’ve dealt with at some point in your life, or at least that you’ve heard of someone else dealing with. When they said, “I’ve got a great deal for you here, she’s a perfectly cheap little runner” the sales person pitched an ostensibly cheap enough price to attempt to obviate any thought of downstream costs. But, thinking it through astutely, … the likely costs of new tyres, transmission or engine repairs, road worthy costs, and potentially many other downstream costs, … the total potential cost would encourage the astute buyer to consider some better alternatives.
The above tongue-in-cheek example coupled to the definition of TCO, alludes to the necessity to be able to build robust TCO models that model the cost of a commodity over its entire life cycle. The image below is a simplistic example of such a model.
The life-cycle costs can be organised into two broad categories i.e. Direct Costs and Indirect Costs. In the IT domain for example, these categories of costs typically comprise the following:
- Direct costs: (Those costs which are typically immediately visible.)
- Hardware and software: g. desktops, laptops, servers, storage, network equipment, license fees, costs of conversion to the new hardware or software plus maintenance costs relating to vendors, spares, and other related supplies and materials.
- Operations: g. technical operations, support and help desk labour costs, database administrators, and software maintenance staff.
- Administration Overhead Allocations: g.. finance, HR, administration, training and procurement department costs.
- Indirect costs: (Those costs which are typically less visible and/or distributed across the organisation’s operations)
- End user operations: e.g. the ‘hidden’ costs incurred when employees gradually evolve to become part of the support structure in addition to their “regular” job (growing the FTE complement).
- Loss of productivity: e.g. when end users are prevented from or impeded from their regular activities when things go awry or break or even when planned maintenance activities must occur, all of which resulting in loss of productivity.
When TCO was originally developed by the research firm Gartner in the late 1980s to determine the cost of owning and deploying personal computers, their initial findings caused quite a stir in the technology community and among CFOs when they discovered how much owning and operating a simple PC cost firms at that time. Over the ensuing years Gartner’s methodology was carefully scrutinised and has been accepted as a standard way to evaluate total costs.
Why TCO Management Is So Critical
TCO management has developed as an invaluable tool for organisations to plan the acquisition of goods, materials and services. As a Leading Procurement Practice, it serves to fulfil a number of key supply chain objectives in support of the organisational mission, such as:
- Providing a structured framework to assess the longer-term implications of purchasing decisions;
- Embracing principles of sustainability by predicting downstream cost exposures over time;
- Lending itself to more effective comparative financial analysis using discounted cash flow methodologies;
- Developing comparative cost baselines/benchmarks against which to assess future cost performance;
- Creating wider understanding that initial costs aren’t the total cost and how specific purchase solutions deliver different downstream cost impacts;
- Creating an important premise for supplier development and second and third tier cost management;
As organisations seek to entrench TCO thinking, particularly in their strategic sourcing endeavours, it is expected that this will create more tightly coupled relationships between Procurement, its internal customers, and vendors, producing solutions that are more sustainable and that reduce the overall costs to the buying organisation. By default, it drives greater collaboration between supply chain role players and also drives ‘We’ thinking as opposed to ‘I’ thinking. Whilst not the panacea to all purchasing objectives and challenges because of its longer-term cost orientation, and its orientation towards more strategic type purchases, it is nevertheless a powerful tool with which to drive effective purchasing decision making and driving down financial costs and risks for the bigger ticket items. With a clear understanding of TCO management, organisations can make more effective purchasing and investment decisions and develop improvement plans that lower overall costs over time without risking the family jewellery.