What Is Total Cost Of Ownership Analysis

Published Date: 02 Nov 2017

Total cost of ownership [1] (referred as TCO in the rest of this thesis) may also be called "Total cost modelling". As emphasised by Ellram (1994a), there is no unique definition of TCO, as it "means different things to different people".

The author decided to chose the following definition of the TCO for this research:

"Total cost of ownership analysis is a structured approach for determining the total costs associated with the acquisition and subsequent use of a given item or service from a given supplier, or the analysis of the total cost of acquisition per se. This is a comprehensive approach that goes beyond price to consider a number of other costs, which might include costs of non-value added activities, service costs, failure costs, administrative costs, maintenance, disposition, and life-cycle costs." (Ellram, 1994a)

According to Ellram (1993a), TCO is a philosophy rather than a merely tool, which aims at "understanding the total cost of a purchase from a particular supplier". Indeed, the TCO is considered as a philosophy because of the cultural change that it may imply: a shift from a price orientation towards a total cost understanding.

Purpose of TCO model and types of purchases considered

For which decision processes to use a TCO analysis?

Depending on the goals of the project, a TCO analysis supports decisions on operational, or tactical, or strategic level, as described in the following chart (figure 2.1).

2.. Various levels of analysis supported by TCO (Ellram, 1994) OPERATIONAL:

Manage and measure suppliers

TACTICAL:

Work on supplier improvement

STRATEGIC:

Improve process

Level of TCO analysis

Goals:

Supplier feedback

Trade performance

Supplier selection

Volume allocation

Allocate costs to products

Identify factors driving high costs both internally and externally

Question fundamental processes

Reengineer processes

Core outsourcing issues

On an operational level, a TCO analysis helps to select a supplier among all the suppliers involved in a tender process. More specifically, it helps to evaluate the bids and requests for proposals, and finally it assists the negotiations by identifying which costs should be challenged.

Besides, a TCO analysis can aid to decide which volume to allocate to a specific supplier (Ellram, 1993a).

Nowadays, more and more companies try to rationalise their supply base and to retain only the best suppliers in terms of low costs, high quality and high responsiveness, in order to gain transparency in their supplier base and to focus the business only on the selected suppliers. The TCO analysis can be taken into account in this supply base reduction process to help for the selection of the suppliers to be maintained into the supply base (Ellram, 1994a).

On a tactical level, TCO analyses evaluate the supplier performance, and above all recognise the supplier’s improvements by comparing the performance measures over time.

On a strategic level, the TCO analysis encourages the processes improvements such as by comparing the "make" versus the "buy/outsourcing" processes (Ellram and Maltz, 1995), or by reengineering the processes such as with new product development.

Types of purchases involved in TCO analysis

A TCO analysis can be undertaken for a wide variety of types of purchases. However, it is not systematically used for all purchases, as it has the drawback of requiring a significant amount of resources and data. Before starting the process of analysing the TCO of a product/service, it is important to assess if this approach will have many benefits (Ellram, 1994a).

A TCO analysis may be undertaken for the four different types of purchases explained in the following matrix (figure 2.2).

2.. Matrix of purchasing types and related reasons to make TCO analysis (based on the matrix of alternative strategic issues from O.Bruel, 2007) Risks levels (internal and external)

-

-

++

++

Economic issue: purchasing turnover

Technical purchases

Reasons to make a TCO analysis:

Manage risks

Improve the processes

Strategic purchases

Reasons to make a TCO analysis:

Manage risks

Deeply understand the costs drivers

Improve the processes

Minor purchases

Reasons to make a TCO analysis:

Save time (computerised TCO model)

Evaluate the outsourcing possibility

Major purchases

Reasons to make a TCO analysis:

Deeply understand the costs drivers

Improve the processes

Strategic and major puchases involve a high purchasing turnover. They represent high dollar value and may be strategically important such as in long term buy. The costs drivers must be clearly explained in a TCO analysis. Therefore, it could help to understand which processes should be improved to lower the costs.

Technical and strategic purchases comprise high quality and technicity buys, for which the market is often not very competitive due to the complexity of the purchases. A TCO analysis can help to manage the risks to manage for these types of purchases, which are significant.

Minor purchases consist of low dollar, repetitive and simple buys (commodities), which are time-consuming. A computerised TCO model can help to save time, so that purchasers have more time to invest into important issues.

Ellram (1994b) interviewed seven companies about their use of TCO in relation with the importance of the purchase, and found out that six of them used TCO for important items such as dollar value and strategic importance (the seventh using it for low dollar purchases and high volume). These companies seem to have used TCO for technical, strategic and major purchases (figure 2.2).

Components of TCO

Types of costs

Depending on the behaviour of the costs in regards with some activity over a given time period, the costs may be variable or fixed, direct or indirect. Ellram and Siferd (1993) provide the following definitions:

Fixed cost: A cost that remains constant, regardless of activity level, over some time frame.

Variable cost: A cost that varies in direct proportion to some activity level.

Semi-variable cost: A cost that contains both fixed and variable elements.

Direct cost: A cost, variable, fixed or semi-variable, that can be directly attributed to some activity.

Indirect cost: A cost, variable, fixed or semi-variable, that supports activities, but cannot be directly traced to any given activity.

Relevant cost: A cost that changes, depending on the activity or decision made.

The total cost of ownership is a cost concept which comprises both direct and indirect costs (Ellram, 1993a). Clearly, Avery (1999) emphasises that a management‘s focus on controlling indirect costs is a means of decreasing the total overall costs.

Other costs concepts involve also direct and indirect costs, such as "life cycle costing" (Jackson and Ostrom 1980), "total cost" (Cavinato, 1992) and "product life cycle costs" (Shields and Young, 1991).

Costs categories from life-cycle analysis

A TCO analysis should include all relevant costs from the different stages of a product life cycle.

Bruel (2007) suggests that a TCO should include the purchasing costs, the supply costs, the after-sales costs and the end-of-life costs, as detailed in the following table (table 2.1).

2.. Costs categories in a TCO model (from Bruel, 2007 - translated into English)

Costs categories

Details

Purchasing costs

Purchasing price per unit

Administrative costs for the purchasing process (sourcing, RFI, tender)

Fixed costs non-recurring (machines)

Fixed costs non-recurring (industrialisation)

Incurred costs (softwares licenses)

Incurred costs (training, documentation…)

Payments conditions

Impact of exchange rates

Supply costs

Logistics costs (transport, storage - installation in warehouses)

Storage costs (according to terms and delivery lead time)

Administrative costs (call delivery, information system)

Reception costs

After-sales costs

Technical support costs (if relevant)

Spare parts costs (out of warranty)

Costs of non-quality (returns and litigations processes costs)

Costs issued by the management of the returns from clients

Downtime costs (delivery delays, malfunctions)

End-of-life costs

Recycling costs of end-of-life products

Reconditioning costs (if relevant)

Cost of repairing in the original conditions

Administrative costs for the management of the end of life of a product

Resale value (if relevant)

It should be noticed that all the costs listed in the previous table do not apply to all purchases. Indeed, even if some total cost factors are commonly used in TCO analysis such as price, quality, delivery and service, the data need to be adapted to each purchase (Ellram, 1994a).

Ellram (1993a, 1993b) groups the costs in three categories, according to the impact on the life-cycle stage of a project: pretransaction, transaction and posttransaction. This transaction-sequence cost components structure involves both direct and indirect costs.

Pretransaction costs:

These costs might include all the costs from the time of idea conception/order requisition to order placement, such as the costs related to the identification of a need, the investigation and the qualification of new sources, or the on boarding process of a new supplier in the system of the company.

These costs are reported in the table 2.1 as "administrative costs" in the category "purchasing costs"

Transaction costs:

The transaction costs are the costs incurred from the order placement to the receipt, such as the purchasing price, the costs associated with the delivery, the tariffs and duties, the inspection, the warehousing, etc. (Ellram, 1994b).

These costs belong to the categories "purchasing costs" – except the administrative costs for the purchasing process-, and "supply costs" in the table 2.3 from Olivier Bruel.

Posttransaction flows:

The posttransaction costs embrace all the costs created from the receipt to the final disposal by the company or consumer, such as the rework costs for parts or finished goods due to a defective part, the costs of returns, the warranty costs, the downtime costs caused by late, defective or incomplete shipments, etc. (Ellram, 1994b).

It also comprises the recycling costs for a product at the end of its life. Some recycling processes might be compulsory in order to respect the law or to protect some data/product, so that the risks of counterfeits and confidential data transmission are minimised.

These costs include the "after-sales costs" and "end-of life costs" of the table 2.3.

Costs categories from Activity-Based Costing analysis

The use of Activity-Based Costing, to provide all relevant costs to be employed in a TCO analysis, was developed by Ellram (1995b) and Roodhooft and Konings (1996).

The Activity-Based Costing analysis links the indirect costs to the activities of a firm, which are identified and described. The activities related to purchasing processes are classified by Degraeve and Roodhooft (1999a) in a four levels hierarchy: the supplier level, the order level, the batch level and the unit level (table 2.2).

2.. Activity levels and costs drivers related

Level

Details

Supplier

Costs assigned to a supplier whenever this supplier is used over the time horizon considered in the procurement decision

(Costs for supplier qualification, for supplier evaluation with quality audit, costs of a dedicated purchasing manager, costs for contract management...)

Order

Costs incurred for issuing each purchasing order with a supplier (example: invoice costs, tariffs and customs)

Batch

Costs related to specific batches, such as reception, transportation, receiving and payment costs, inspection of the received order...

Unit

Costs related to the individual units of the products such as unit purchase price, failures, inventory costs, and quality control cost for the inspection of each item

The Activity-Based Costing analysis provides a methodological framework for the costs assignment to activities on different hierarchy levels (Weber and others, 2010, Degraeve and others, 2000). Besides, activity-based management systems were also used by Bennett (1996) in a process of measurement and reduction of the overall costs.

The costs identified with an Activity-Based Costing analysis can be used for a TCO approach. However, the costs for TCO analysis require more details than in Activity-Based Costing analysis, as the costs need to be detailed by supplier and by item purchased (Ellram, 1995b, Degraeve and others, 2000). According to Ellram (1995b), the use of Activity-Based Costing methodologies is a critical factor impacting the effective implementation of the total cost of ownership modelling.

At the end of the day, a TCO method based on Activity-Based Costing to determine the costs was undertaken by many authors (Ellram, 1995; Roodhooft and Konings, 1996, Degraeve and Roodhooft, 1999, and Weber and others, 2010), and helped in the supplier evaluation and selection processes.

It can be noticed from the previous table that not only manufacturing activities create costs, but also purchasing activities, such as in the supplier’s level. Ellram and Siferd (1993) analysed the purchasing activities contributing to the TCO (figure 2.3): management, delivery, service, communication, price, and quality.

purchasing activities contributing to TCO Ellram and Siferd 1993.png

2.. Purchasing activities contribution to the total cost of ownership (from Ellram and Siferd, 1993)

Costs drivers (Pareto)

In order to do some savings, it is important that a purchaser focuses his time on the elements which drive the costs of a product or service. A Pareto analysis or an ABC analysis can be undertaken, in order to identify these elements.

According to the Pareto’s law, 20 percent of the cost elements contribute to 80 percent of the dollar costs.

An ABC analysis goes further than a Pareto analysis by classifying the costs into three categories (figure 2.4):

Category A: 20% of the costs elements represent 80% of the total costs of the product or service

Category B: The 30 % other costs elements represent 15% of the total costs of the product or service

Category C: The remaining 50% of costs elements represent 5% of the total costs of the product or service

Total cost of the product or service (in %)

Costs elements (in %)

2.. Categories A, B and C (Pareto analysis)

The costs drivers are defined as the costs representing the largest part of the total costs of a product or a service (Bruel, 2007). These costs represent the category A of an ABC analysis (Pareto’s law). Indeed, Ellram (1994b) suggests the use of the Pareto’s Law, "to capture the 20% of the issues that make up 80% of the costs".

Milligan (1993) emphasises that an accurate total costs measurement is elusive, since most organisations face two main issues: either they don’t understand the calculations, or the data necessary for these calculations are missing, because they don’t have or won’t share them. However, the problem of an accurate total cost measurement is overcome with the Pareto’s law: an exact accuracy of the TCO analysis is not such a big deal, as long as the key critical cost items accounting for a large part of the TCO are identified. A comparison of TCO analyses is valid provided that the evaluation of alternatives is founded on the same critical factors, called "costs drivers" (Ellram, 1994a).

Frequency of use: unique VS standard models

Even if TCO measurements are undertaken within companies, the TCO analyses are not always formalised. A formalised model is defined as" a written, documented methodology" (ELLRAM, Lisa M., 1994b). Ellram and Siferd (1993) questioned 103 purchasing personnel about their use of TCO analysis. The results of this survey were the following: 18 % of them used a formal TCO system, 25 % did not use it, and the remaining 58 % had an informal approach to TCO.

Ellram (1994a, 1994b, 1995a) observed two basic formalised models: the unique model and the standard model.

Some models are developed for a one-time buy or a long-term decision such as make/buy or outsourcing decision, and are not meant to be specifically reused. Therefore, unique models are created by the users, in order to be fully adapted to a specific item or purchase situation. Ellram (1994b) states that the costs elements vary in general significantly among unique TCO models.

On the contrary, when the purchases are repetitive and/or when different purchases share the same issue of concern, it can be efficient to create a standard model. This efficiency can also be improved by computerising the model into the organisation's system, which creates value only for a standard approach, rather than for a unique model. Ellram (1994b) assesses that in general, a standard model is supported by a computer-based model.

A standard model implies that little or no modifications are needed concerning the costs elements identified and the basic way the costs are calculated. Therefore, Ellram (1994b) defines it as a "ready to go" package, where all relevant costs for a specific purchase are plugged in and irrelevant costs are deleted.

The following table (table 2.4) explains whether to use a standard or unique model, depending on the type of buy.

2.. Determination of whether to use standard or unique models (Ellram, 1994a)

Nonrepetitive Buys

Repetitive Buys

Type of Buy

Productive Capital

Major Acquisitions, make-buy or process analysis

Supplier selection with no or ad hoc updates

Ongoing supplier performance monitoring, perhaps selection

Recommended TCO Approach

Develop a model for capital that can be adapted for other capital purchases

Develop a unique model that fits that buy, and can be updated to evaluate actual performance versus estimate

Develop a "standard" model that can be used across buys, manual or computerized

Develop a "standard" computerized model that is automatically updated monthly or quarterly, can be used across buys

Valuation approach

Two main methods of assigning cost data to TCO elements can be used: monetary-based and value-based.

Monetary-based

A monetary-based system consists of collecting and assigning actual cost data (from accounting systems or via formulae) for each of the relevant TCO component. An example of dollar-based TCO model is presented in the figure 2.5

dollar-based model.jpg

2.. Dollar-based TCO illustration (from Ellram, 1995a)

This model is objective and aims at capturing the actual costs (Ellram, 1994a, 1995a). An advantage of this model is that the results are easily understandable. Sometimes, some formulae are used to have a more accurate idea of the true costs of doing business (Ellram, 1995a). Ellram (1993a) provides the following examples of formulae:

Value-based

A value-based model combines quantitative data with associated costs and qualitative data, which are transformed into quantitative data with cost adders (Ellram, 1995a). A cost factor is created by using the indices and weighting factors, such as with a scorecard approach. This costs factor adjusts the supplier’s quoted/bid price, by taking into account some qualitative criteria, such as quality.

Contrary to a monetary-based model, this model can outline the importance of lack of performance such as late delivery or rejection rate. However, the scorecard rating involves subjective judgement, which is not the case with monetary-based model (Weber and others, 2010). Another drawback of this model is that is becomes easily complex.

The following figure (figure 2.6) provides an example of a value-based model. It can be seen that a weighting factor of 1.08 is affecting the cost per unit. The weighting factor takes into account qualitative elements, such as quality and delivery. Concerning the delivery, the score was estimated about 19 out of 20 (maximum score), representing the fact that the deliveries are not 100% on time, but rather 99% on time. This is how the qualitative factors can be taken into account in a value-based model.

value-based TCO model.jpg

2.. Value-based TCO illustration (from Ellram, 1995a)

Competitive and operative benefits of TCO analysis

Improvement in terms of understanding and decision making

By establishing the costs structure of a product through its lifecycle, the company can understand the processes, clarify the specifications required and identify how much the firm is willing to pay for them, and define the supplier performance expectations. The TCO is a proactive way helping purchasers to understand what is driving costs and to consider a product in a long term vision, rather than a sole price (Ellram, 1993a, 1994a, 1994b, Ellram and Siferd, 1998, Ferrin and Plank, 2002). Furthermore, once the processs are understood, the process improvement potentials can be identified by analysing TCO (Degraeve and others, 2005; Ellram, 1994b).

Moreover, the TCO approach is an objective tool that enables an evaluation of a supplier performance, and a comparison to other suppliers and a measurement over time, which eases the decision-making by reducing subjectivity (Ellram, 1993a, 1994a, 1994b). Indeed, Roodhooft and others (2003) evaluate a potential supplier by using an Activity-Based Costing model to suppor a TCO analysis. Therefore, TCO aids the purchaser in supplier selection and in ongoing supplier management. Degraeve and Roodhooft (1999b) illustrate this benefit of using the TCO in supplier selection: a mathematical programming optimisation model based on TCO minimisation helped to select suppliers for heating elements and ball bearings. This resulted in costs savings respectively of 8 % and more than 10 %.

Positive effects on the relationship with the supplier

The purchasing has a clear view on the cost structure of a product/service of a supplier. Firstly, these data can help the purchaser for negotiations with the aim of reducing costs, as it was done by Degraeve and others (2004) for the negotiations for the purchase of a service with different airlines (resulting with the entire TCO analysis in 19.5% savings compared to the ad hoc policy). In return, this can be beneficial for the supplier, as he knows exactly which performance areas to improve (Ellram, 1993a, 1994a, 1994b). Indeed, Carr and Ittner (1992), and Ellram (1993a) state that TCO data help to improve and evaluate the supplier performance. This supports the firm’s overall continuous improvement effort, by creating savings opportunities and quality enhancement (Ellram, 1993a).

Then, the supplier can also better justify some higher initial costs because of a high quality, resulting in lower maintenance costs. Consequently, this transparency of data is beneficial both for the purchasing and the suppliers, which results in an enhanced communication and an improved relationship (Ellram, 1993a, 1994a).

Improved communication internally and mutual recognition between departments

The TCO analysis has a double positive effect internally between the different departments of an organisation.

On the one hand, the purchasing organisation is acknowledged within the company as an entity creating value since savings can be quantified. TCO approaches enable positive impacts on the purchasing’s role in decision making, as their value is recognised among the company (Ellram, 1994a). Carr and Ittner (1992) think that TCO systems enhance the performance of a purchasing department.

On the other hand, purchasing does work alone but in a team with the inputs of all the other functional departments involved in the project, such as "planning, finance, accounting, engineering, quality and operations" (Ellram, 1993a). Purchasing acknowledges the help and the value added by the members of this team, and takes their concerns/requests into account.

As a result, the use of the TCO is way to create and pursue a proactive and collaborative relationship between the departments of an organisation.

Challenges concerning the TCO implementation

In her case study analysing the use of TCO among American companies, Ellram (1994a) lists the challenges, difficulties concerning the implementation and usage of TCO: relevance of TCO models, data availability, complexity, and corporate culture. She emphasises that effective use of TCO is not simple, and that no standard implementation procedure exists.

Relevance of TCO models

As stated above in 1.2.2, the use of TCO is not appropriate for all purchases.

Indeed, the TCO approach must be used only when the benefits of this tool exceed the efforts for implementation.

Data availability

As emphasised by Ellram (1993a), "while total cost of ownership is fairly simple to grasp conceptually, in practice the complexity of gathering TCO data may limit its widespread adoption".

First, the data required for calculating the TCO must be defined (Ellram, 1994a). This should be done not only by the purchasing, but also with the inputs of all the departments which are related to the product/service purchased. It is not easy to determine the relevant cost data for TCO, as emphasised by Bremen and others (2007).

Then, the data required for the TCO may be difficult to obtain (Ellram, 1994a, 1995a, Weber and others, 2010, Ellram and Siferd, 1998). Sometimes, this can be due to a lack of costs tracking concerning some elements of the lifecycle of a product, such as how much is spent in maintenance costs (Ellram, 1994a). This is especially the case when neither an automated TCO system linked to TCO data nor common cost information data base exist. In these cases, the required data need to be developed by exploiting other data available within the company, or by gathering the data from the system of the supplier. Morssinkhof and others (2011) analysed the impacts of missing information for TCO on attribute weights in purchasing decisions. They found out that the practitioner participants gave less weight to the missing attribute than the student participants. As a result, the amount and quality of TCO information have impacts on the purchasing decisions, which differ among the purchasers depending on their experience.

As a result, the lack of computers systems/information in order to support the TCO analysis has been identified as the major resource problem by Ellram (1993a) in a case study involving seven companies. Undeniably, the data collection is a labour intensive process when no computer system of the company can provide the required data, because thus the data must be collected manually.

Complexity

A TCO analysis is not an easy task to do. First of all, it is time-consuming to develop (Ellram, 1994a), as data need to be defined and collected, in consensus with all the other departments linked to the product/service. Clearly, Ellram and Maltz (1995) state that "TCO analysis is reserved for relatively large/ important decisions, due to the amount of work required to conduct a thorough analysis.’’

Secondly, the model should not be too complex or too detailed (Ellram, 1994a), in order to be understandable by all people involved in the decision process, and by the supplier. Besides, the more complex a model is, the more difficult it will be to acquire all the data required. Therefore, the costs drivers - including underlying cost drivers - should be appropriately identified, which might raise some issues (Ferrin and Plank, 2002).

Finally, the model should be adaptable – and for that reason, not too complex- as the factors incurring the costs are continually varying (Ellram, 1994a).

Corporate culture

The TCO approach implies a shift from a "purchasing price" to a total cost analysis (Ellram, 1993b and 1994a). This cultural change may not be accepted by everybody in the organisation, which might result in higher difficulties to obtain the necessary data (Ellram and Siferd, 1998).

Key success factors for implementing a TCO analysis

Ellram (1994a) proposes a 10-steps model for developing and implementing a TCO analysis (figure 2.7).

2.. A 10-step approach to implementing TCO analysis

Out of this approach to implement a TCO analysis, and based on the cases studies analyses in the literature review, it has been found that key critical factors for a successful implementation are the training and education, and the top management suport.

Training and education

Even within a company, the TCO models vary significantly. Therefore, a training and education explaining the TCO concept, the uses and benefits of a TCO analysis, and providing examples of TCO models to know how to run a TCO analysis, can be useful to support the TCO efforts (Ellram, 1993a). These trainings develop the awereness of TCO measurements of the employees, and help to solve the issue of relevance of TCO models, complexity and corporate culture.

Top management support

As in all/many decisions concerning change management, the changes of processes are better accepted when there is a support of the top management. This is a major key success factors for implementation which has been identified by Ellram (1994a). The top management should provide guidelines to improve the consideration of TCO analysis, and support multifunctional groups for TCO analyses, with purchasing playing a key role.

This will support the involvement of other functions (engineering, quality, internal customers, marketing, accounting...) in the TCO analysis, which increases their understanding and acceptance of this long term view. They can support this project by bringing in their expertise and help to collect the data, which enhances the accuracy of the TCO model.

As the project gains in visibility throughout the different departments of the firm, an effective implementation within the company is enhanced (Ellram, 1993a).

In their survey involving 160 purchasing managers and 150 maintenance representatives, Wouters and others (2005) proved the importance of top management support and functional (non-accounting) commitment to obtain improved cost information. They emphasised that the commitment of functional management is highly impacted by the top management support. They even state the role of the top management as "crucial" to support new accounting practices.

To conclude, the top management support is the key to solve the issues of data availability and corporate culture.