Introduction to TCO
TCO stands for Total Cost of Ownership. It came into the spotlight in the 80s in the IT business. Managers discovered that supporting the equipment and software could cost between 5 to 8 times the purchase price. This concept was later introduced to Procurement departments.
Total Cost of Ownership (TCO) is a financial estimate that helps consumers and business owners determine direct and indirect costs of a product or system. TCO goes beyond the outlay and embraces all the ongoing financial commitments for owning, operating, maintaining and disposing a product.
Total Cost of Acquisition (TCA) is the purchase price plus all other costs needed to purchase the item and get it to the point of use. We can simplify both definitions with the following graph:
TCO Benefits
1) Improve cost visibility
Gain visibility to all costs associated with procurement
2) Maximize value
– Maximize savings and value on the administrative, operating and maintenance costs
– Increase productivity & reduce workload
– Justify an intended acquisition
3) Improve supplier relationship management
– Quantify and include various supplier services into the price structure
– Give an overview of the product life cycle cost
– Highlight potential risks
Practical Example
Let’s say you buy a car that’s inexpensive, but breaks down constantly. When you take it to get fixed, you find that the repair shop is far away and the parts are costly. It also loses value faster than other cars that cost more when it comes to resale. Your time is also valuable and all of the trips to the repair shop should be taken into consideration, too. So, let’s do the math:
- Car A
Initial cost: 10,000€
5 years of repairs, plus normal maintenance: 7,500€
Value after 5 years when you sell it: 1,000€ - Car B
Initial cost: 20,000€
5 years of repairs, plus normal maintenance: 2,000€
Value after 5 years when you sell it: 10,000€
The 5 year TCO of Car A is 16,500€, whereas the 5 year TCO of Car B is 12,000€. Even though Car B was more expensive up front, it costs less in the long run.
Findings
The above example is a very simple calculation we can encounter in our daily life. It sounds like common sense to take operation (gas consumption) and maintenance (repairs) costs into consideration before purchasing a car. However, it’s surprising to see some businesses not applying these TCO calculations when going through a sourcing process. Focus is primarily given to the purchase price (TCA), while operation, maintenance and disposal costs remain unknown or hidden.
Operation and maintenance costs are sometimes omitted from supplier offers and is up to the buyer to ask and challenge suppliers to understand all the TCO costs. In this sense, the more expertise about a category, the better negotiation and better cost the buyer is able to achieve. This fact enhances the importance of implementing category management in every Procurement department, enabling the specialization of each buyer.
Later, in addition, we encounter a new problem when operation and maintenance invoices arrive and the business does not associate the expense with the purchase of a specific product. These costs are mainly tagged as “miscellaneous” and “other” costs, losing the visibility of the total cost of ownership of the purchased products.
It may seem common sense to make a complete TCO calculation before purchasing any product, but believe me, unfortunately this is not a common practice!
A common practice is to sign the deal only having visibility of the top part of the iceberg, ignoring or not paying close attention to the big expenses hidden below the water.