Total cost of ownership (TCO) is the sum of all costs associated with every activity of the supply stream during the acquisition of a given service, component or product. During the sourcing process, a TCO analysis groups certain cost inputs into specific categories to display the full visibility of all costs when making a sourcing decision. These costs are commonly referred to as direct costs, indirect costs, acquisition costs, life cycle costs, purchase price, and end of life costs. Together, these cost categories represent not only the purchase price of the service, component or product but also the cost of acquiring it, maintaining it, and disposing of it.
In simpler terms, many supply professionals group these costs into two categories: production price, and landed costs. The production price includes the cost per unit of direct materials, labor, and overhead (cost of goods sold). Landed costs include all production costs plus, logistics, warehousing, transportation, and material handling. Although landed costs are often the most important and highest cost input line items within a TCO analysis, it is critical that the supply chain team carefully analyzes process change costs and ongoing costs as well so that they have a full view of all costs. An effective TCO analysis requires understanding all costs inputs that help differentiate between alternative sourcing strategies. Whether your company is manufacturing a component or product at your own facility or sourcing a component or product to a supplier or contract manufacturer it is critically important to have visibility and a detailed understanding of all of the cost inputs. Below is a list of the major three cost categories: landed costs, process change costs, and ongoing costs, and their associated cost inputs, that make up a detailed TCO analysis.
Landed Costs are the total acquisition costs of goods. Below is a list of the key landed cost inputs to include in a detailed TCO analysis:
- Purchase price (components)
- Transportation (inbound/outbound)
- Dunnage (racks, packaging)
- Customs (duties, taxes, fees)
- Inventory (carrying, ordering)
- Outsourcing (manufacturing services)
- Monitor and controlling (managing outsourced relationships)
Process Change Costs are the costs of evaluating choices and implementing changes. Below is a list of the key process change cost inputs to include in a detailed TCO analysis:
- Requirements research (technical requirements)
- Resourcing process (assembly instructions)
- Legal review (new contracts)
- Supplier integration (information systems setup)
- Implementation (movement of tooling)
- Process change and training (production ramp up)
- Transition (component inventory buildup)
Ongoing Costs are the cost of life cycle ownership. Below is a list of the key ongoing cost inputs to include in a detailed TCO analysis:
- Life cycle (quality, durability, maintainability versus price)
- Maintenance repair and operations (service process)
- Service components (current and future component piece price)
- Quality (defects, repairs, rework, warranties)
- Reverse logistics (returns)
- Sustainability (recycling, recovery of materials)
- Reputation (customer loyalty versus lost customers)
TCO will measure the net effect of all cost increases and decreases in your component, product or service if you include the above three cost categories and key cost inputs in your TCO analysis. It is critical to be consistent in the choice of cost inputs to include in your analysis for the accurate comparison of multi-period measurement or competing supply alternatives. Once your team has chosen the cost inputs that will be involved in analyzing the total cost of ownership, it is time to plug in the cost numbers and analyze the net effect over a fixed period of time in order to make a TCO sourcing decision.
TCO Implementation & Benefits
Using TCO analysis requires a commitment to supply chain cost management excellence within a company. TCO needs to be understood by all team members and supporting processes need to be put in place to record and track results from TCO analyses. Without full adoption and alignment of management incentives toward total cost, good procurement decisions may be viewed as negative impacts to department budgets due to potential high upfront costs. With full adoption of TCO analysis, those potential high upfront costs are seen as a long term cost reduction rather than an initial short term cost increase. Over the long term, the implementation of TCO analysis for sourcing decisions can be very beneficial to a company’s bottom line. When properly implemented, TCO can help organizations and supply partners make and justify wise, cost-effective choices for the long term success of the company and the entire supply base.