CHAPTER ONE

TOTAL COST OF OWNERSHIP (TCO)

Learning objectives

At the end of the chapter, students will be able to:

 Understand the concept of TCO
 Identify importance of TCO
 Know factors included in TCO study
 Differentiate TCO and NPV

1.1. Introduction

TCO is a financial estimate whose purpose is to help consumers and enterprise managers determine
direct and indirect costs of a product or system. It is a management accounting concept that can be
used in full cost accounting or even ecological economics where it includes social costs. For
manufacturing, as TCO is typically compared with doing business overseas, it goes beyond the
initial manufacturing cycle time and cost to make parts. TCO includes a variety of cost of doing
business items, for example, ship and re-ship, opportunity costs, while it also considers incentives
developed for an alternative approach. Incentives and other variables include tax credits, common
language, expedited delivery, customer oriented supplier visits. Formally, total cost of ownership
defined as the sum of all expenses and costs associated with the purchase and use of equipment,
materials and services. To use a total cost approach, a firm must define and measure a purchased
items major cost components. Total cost of ownership requires a purchaser to identify and measure
costs beyond the standard unit price, transportation and tooling when evaluating purchase
proposals or supplier performance. Firms that accurately measure the total cost of ownership have
the ability to identify variances from planned results and can take corrective action to reduce future
problems.
 The total cost of ownership (TCO) concept extends beyond purchasing. TCO can
be viewed as an extension of cost driven accounting system such as Activity Base
Costing (ABC), which strives to allocate cost to appropriate drivers according to

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 their value-added component.
 In this respect, TCO extended ABC to not only external sources of supply, but also
to other value-adding activities both up and down-stream from the organization.
 Armed with better information about cost, such systems allow managers to make
decisions regarding procurement strategy, market and pricing strategies and other
industry trends. New and relevant performance measures, which provide true
assessments of total cost, can be developed to permit an integrated approach to
supply chain management.
 In order to develop a TCO model, purchasing managers must have a framework
within which to work. While the TCO concept relatively well known within
industry, a cohesive decision support system for implementation is required.
System can help change the way manager’s thinks about measuring different
attributes of supply chain activities and can help focus their attention on measures
that reduce total cost and affect profits.
 A problem with total cost analysis is that firms do not have the systems to collect
and interpret total cost data;
Lack of computerized system to collect TC data
Lack of accounting systems to capture cost data in the needed format

Total cost data must come from a number of different functions within a firm. Activities as diverse
as finance, accounting, quality assurance, manufacturing, receiving, inspection and purchasing
information it can be difficult to coordinate the collection of data from diverse organizations
functions, particularly with a manual data collection system. Purchasing plays a critical role in
total cost analysis. It is the logical function to manage a total cost system because of its close
interaction with function inside and outside the firm, and its reliance on total cost data support the
sourcing process.

1.2. The Importance of Total Cost Ownership (TCO)

* Total cost of ownership measurement is increasingly important as purchasing strives to select

the lowest total cost source of supply (not the lowest price). TCO applies not only to items sourced
from external suppliers but also to internally manufactured items. Companies implement total cost

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systems to realize very specific benefits.

* Select supply sources based on total cost considerations, including not only the evaluation of
external suppliers but also comparisons to internal suppliers manufacturing capabilities. The total
cost of ownership approach directly supports make-or-buy analysis.

* Increase supplier performance by identifying areas of nonperformance along with responsibility

for corrective action.

* Clearly define performance expectations and communicate those expectations to suppliers.

- Suppliers often complain that poor communication between firms is a leading reason for poor
performance.

- Total cost systems should have a feedback mechanism that provides positive and negative
supplier feedback. It also provides critical data for target pricing, and provides a long-term
orientation by focusing on cost reduction over an extended horizon.

* Increase supplier accountability and control.

Total Cost of Ownership, or TCO, has become an extremely important metric often used by
consumers and businesses to compare two similar products. TCO is a financial concept that
combines the initial acquisition costs for a product with the operational costs of using the product
over its expected life. For many classes of durable goods, a comparison of two products based
solely on purchase price can lead to very inaccurate conclusions.

Over the past decade, the concept of TCO has grown in importance. The computer and automotive
industries are two examples of industries where TCO is commonly promoted.

Total cost requires purchasing to develop an awareness of most significant on price factors under
the jurisdiction/without discrimination supplier contribute to total cost. Select preferred suppliers
based on performance merit. The practice of developing partnerships with suppliers over an
extended period requires comprehensive performance data. Total cost data allow a firm to rank
suppliers and select only the best suppliers.

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 Introduce measurement discipline throughout the organization by relying upon an
equitable and consistent evaluation. Total cost measurement information can be used
in a number of managerial activities. Provide the ability to quantity & communicate to
supplier areas of non-performance to concentrate supplier performance improvement.
 TCO analysis draws from variety disciplines such as;

 Finance –net present value (NPV) analysis

 Accounting- product pricing & costing

 Operations mgt – reliability and quality

 Marketing-understanding and meeting customer wants.

 IT- system integration and e-commerce

 Logistics- materials movements

 Economics- minimum average total unit cost of production.

 TCO practice to strategic optimization with the supply chain/ supply network
Supply chain involved the upstream & downstream flows of products, services,
finance and information from source to customer.
 At this time TCO analysis;

- The manufacturing of the product (VE/VA)

- The manufacturing infrastructure requirement, i.e. the basic facilities, service

and installations needed for the optimal function of manufacturing operation.

- Whether to outsource or self-manufacture

- The abilities /location/ responsiveness/ potential of suppliers relative to the

manufacturing operation

- The structure of foreign and domestic tariffs/duties/taxes

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 - Costs of transportation & time of delivery

- Inventory costs- damage, obsolescence

1.3. Factors Included in a Total Cost of Ownership Study

 System pricing,

 Service contract costs,

 Installation and training costs (if any),

 Energy costs,

 Ongoing management and maintenance costs, and

 Reliability costs.

Depending on the type of study, cash flow analyses can compare the true long-term costs of owning
different systems or the cumulative costs associated with upgrading one system with another.

Activity1:

1. What factors should be considered in TCO study?

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1.4. Components of Total Costs

1) Acquisition costs: - are the initial costs associated with the purchase of materials, products
and services. These are not long- term costs of ownership, but rather represent an immediate
cash outflow. The acquisition costs including purchase price, planning costs, quality costs, and
taxes and financing costs. Acquisition/Physical Hardware costs include the cost of equipment

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 or property before taxes, but after commissions, discounts, purchasing incentives, and closing
costs. Sometimes this will include one-time peripheral equipment or upgrades necessary to
installation or utilization of the asset.

Purchase price- the price paid direct or indirect for materials to be purchased.

Planning costs- the costs of developing requirements and specifications, initial processing and
monitors quality costs- selecting and certifying a supplier to obtain the optimal level of quality and
monitoring the results using.

Taxes- firms must address the impact of taxes both direct (duties, processing fee) and indirect
(foreign taxes, tolls, facility fee) on the cost of procured materials and products.

Financing costs- a business of finance acquisition are using cash, debt financing lines of credit,
capital leases & bonds.

2) Ownership costs/ Operating Costs: - Operating costs include subscriptions or services needed
to put the item into business use. This includes utility costs, direct operator labor, and initial
training costs. The costs after the initial purchase, associated with the ongoing use of purchased
product, material or item of equipment. Ownership costs are quantitative and qualitative.
Quantitative costs examples are energy usage, maintenance and repair. A qualitative cost is
difficult to quantify when making purchase. E.g. ease of use (time saver), aesthetic
(psychologically pleasing to the eye), ergonomic (maximize productivity reduce fatigue).

3) Post-ownership costs: - in the past, salvage value and disposals costs were the major inputs
required when estimating post-ownership costs of capital purchases. These cost could be estimated
a cash inflows (the sale of used plant & equipment) or outflows (demolition of an obsolete facility).
The purchaser was an established market that provided data to help estimate reasonable futures
values. Supply management address impact on long- term potential when performing TCO
analysis regarding environment impact, unanticipated warranty and product liabilities & the
negative marketing implications of low customer satisfaction. Environmental costs-unplanned
expenditure of replacing their underground environmentally friendly like pollution & unsafe.

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 Activity2:

1. Take one company that purchased new equipment and calculate the acquisition cost of the
equipment.

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1.5 TCO, NPV (Net Present Value) and Estimated Costs

 The difference between the present value of the future cash flows from an investment and
the amount of investment. Present value of the expected cash flows is computed by
discounting them at the required rate of return.

 The Net Present Value (NPV) of an investment is the present value of the expected cash
flows, less the cost of the investment.

 Net present value is the difference between the market value of a project and its cost.

How NPV Works

NPV will always appear as a dollar amount in one of three ways: greater than zero, zero, or less
than zero. We have to examples below that illustrate an amount that is greater than zero and less
than zero to give you the idea.

EXAMPLE A: Let's assume that the PV of all future cash flows is $110,000. We would calculate
NPV by subtracting $100,000 (the initial investment) from $110,000 (the PV of all future cash
flows).

NPV = $110,000 - 100,000 = $10,000

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EXAMPLE B: Let's assume that the PV of all future cash flows is $90,000. We would calculate
NPV by subtracting $100,000 (the initial investment) from $90,000 (the PV of all future cash
flows).

NPV = $90,000 - 100,000 = -$10,000

What it means

When NPV is greater than zero it means that the discounted value of future cash flows is greater
than your initial investment and you would be getting an even higher return than you desire.

When NPV is zero it means that the discounted value of future cash flows equals your initial
investment and you would be getting exactly the return you desire.

When NPV is less than zero (a negative number) it means that the discounted value of future cash
flows is less than your initial investment and you would be getting a lower return than you desire.

Okay, let's interpret our two examples.

EXAMPLE A: With an NPV of $10,000 (greater than zero) you would be getting a good deal for
the property based on your desired yield because you have exceeded it.

EXAMPLE B: With an NPV of -$10,000 (less than zero) you would be paying too much for the
property based on your desired yield. You must either buy the property for less or lower your yield
if you want to pursue this property.

Method of evaluating a potential investment is

-to analyze the present value of the initial expenditure (initial cash payment)

- Future revenue streams (cash receipts, reduction of expenses).

-future expenditure streams (cash payments elimination of revenues).

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Analysis discount the positive and negative streams using an interest rate usually referred to as the
opportunity cost of holding capital the minimum required rate of return a business expects to
receive on its investment. The opportunity cost of capital is linked to the riskiness of the investment
and the firm’s capital structure (weight average cost of capital). TCO and NPV analyses are very
similar in philosophy. Both attempt to estimate and analyze the acquisition costs, operating costs
and post- ownership costs in terms of value to be received by the company. In addition, NPV
analysis attempts to analyze revenues and other cash flows. TCO focuses on estimating and
analyzing the ownership and post- ownership costs. An expense that has been forecast and which
pertains to a given business purpose, product or project. An example of an estimated cost might
be a forecast made for the expenses involved in servicing a product that is still under warranty
after it has been sold to a consume.

Formula represents simplified TCO analysis:

TCO = A+PV (Ti + Oi + Mi –Sn)

Where TCO – total cost of ownership

A –acquisition cost

PV – present value

T- Training cost in year i

O – Operating cost in year i

M – Maintenance cost in year i

S - Salvage value in year n

PV = FV

(1 + r) t

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 Where PV-present Value

FV- Future value of inflows or outflows of cash

r- Discounted rate per period

t- Total number of periods

PV annuity = CF [1/r-1/r (1+r) t]

CF- periodic cash inflow or outflow (it must be the sum each period)

SUMMARY

 Total cost of ownership defined as the sum of all expenses and costs associated
with the purchase and use of equipment, materials and services.
 The importance of total cost ownership are to select the lowest total cost source of
supply, to clearly define performance expectations, Increase supplier accountability
and control.
 Some of the factors included in a total cost of ownership study are System pricing,
Service contract costs, Installation and training costs (if any), Energy costs, ongoing
management and maintenance costs, and Reliability costs.
 Total costs are composed of Acquisition costs, Ownership costs/ Operating Costs and
Post-ownership costs.
 Net present value is the difference between the market value of a project and its cost.
 TCO and NPV analyses are very similar in philosophy.

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