Chapter 13
Total Cost of Ownership
13-1
Total Cost of Ownership
•
Total cost of ownership is a philosophy for really understanding all
supply chain related costs of doing business with a particular supplier
for a particular good or service (Lisa Ellam, May 1999)
TCO
13-2
Key Concepts
•
Three Components of Total Cost
»
Acquisition Costs
»
Ownerships Costs
»
Post-Ownership Costs
•
Purchase Price: But One Component of Cost
13-3
Key Concepts
•
TCO, Net Present Value Analysis (NPV), and Estimated Costs
•
The Importance of Total Cost of Ownership in Supply Management
»
Service Providers
»
Retail
»
Manufacturing
13-4
Three Components of Total Cost
•
Acquisition Costs
•
Ownerships Costs
•
Post-Ownership Costs
13-5
TCO Components
•
Acquisition costs
»
Purchase price
»
Planning costs
»
Quality costs
»
Taxes
»
Financing costs
•
Ownership costs
»
Downtime costs
»
Risk costs
»
Cycle time costs
»
Conversion costs
»
Non-value added costs
»
Supply chain costs
•
Post-ownership costs
»
Environmental costs
»
Warranty costs
»
Product liability costs
»
Customer dissatisfaction costs
TCO
13-6
Acquisition Costs
•
Purchase Price
•
Planning Costs
•
Quality Costs
•
Taxes
»
Customs Duties and Tariffs
»
Regional Trade Agreements
»
Income-Base Shifting
•
Financing Costs
13-7
Ownership Costs
•
Downtime Costs
•
Risk Costs
•
Cycle Time Costs
•
Conversion Costs
•
Non-Value Added Costs
•
Supply Chain Costs
13-8
Ownership Costs
•
Supply Chain Costs
»
Forecasting
»
Administration
»
Transportation
»
Inventory
»
Manufacturing
»
Customer service
»
Supplier selection/relationships
»
Global sourcing
13-9
Post - Ownership Costs
•
Environmental Costs
•
Warranty Costs
•
Product Liability Costs
•
Customer Dissatisfaction Costs
13-10
TCO, Net Present Value Analysis (NPV), and Estimated Costs
•
NPV analysis is frequently incorporated into TCO analyses
•
NPV analyzes present values of the initial expenditure along with the
likely future revenue and expenditure streams
•
The present value of a sum of future cash flows discounted by a required
rate of return
»
NPV greater than zero suggests accepting the investment
»
NPV less than 0 suggests rejecting the investment
»
NPV = 0 is the point of indifference
13-11
Tangential Reprographics Example
Required rate of return 20.00%
Year NOW 1 2 3 4 5 6
Present
Value
Cost of machine including
installation and testing (actual)
(120,000) (120,000)
Manufacturer required overhaul
(estimated)
(9,000) (5,208)
Cash inflows generated by using
machine (estimated)
40,000 40,000 40,000 40,000 40,000 40,000 133,020
Cash outflows incurred by using
machine (estimated)
(7,000) (7,000) (7,000) (7,000) (7,000) (7,000) (23,279)
Salvage value (estimated) 7,500 2,512
Net present value of potential
investment
(12,955)
Total of annual streams (from above) (120,000) 33,000 33,000 24,000 33,000 33,000 40,500
Required rate of return 20% 20% 20% 20% 20% 20%
Sum of present value of annual
streams equals net present value of
potential investment
(120,000) 27,500 22,917 13,889 15,914 13,262 13,563 (12,955)
Internal rate of return (120,000) 33,000 33,000 24,000 33,000 33,000 40,500 15.66%
(Alternative Method)
Tangential Reprographics
Net Present Value Analysis - Copier
Required rate of return 20.00%
Year NOW 1 2 3 4 5 6
Present
Value
Cost of machine including
installation and testing (actual)
(120,000) (120,000)
Manufacturer required overhaul
(estimated)
(9,000) (5,208)
Cash inflows generated by using
machine (estimated)
40,000 40,000 40,000 40,000 40,000 40,000 133,020
Cash outflows incurred by using
machine (estimated)
(7,000) (7,000) (7,000) (7,000) (7,000) (7,000) (23,279)
Salvage value (estimated) 7,500 2,512
Net present value of potential
investment
(12,955)
Total of annual streams (from above) (120,000) 33,000 33,000 24,000 33,000 33,000 40,500
Required rate of return 20% 20% 20% 20% 20% 20%
Sum of present value of annual
streams equals net present value of
potential investment
(120,000) 27,500 22,917 13,889 15,914 13,262 13,563 (12,955)
Internal rate of return (120,000) 33,000 33,000 24,000 33,000 33,000 40,500 15.66%
(Alternative Method)
Tangential Reprographics
Net Present Value Analysis - Copier
13-12
TCO Formula
n
TCO = A + P.V. Σ (T
i
+ O
i
+ M
i
– S
n
)
i = 1
A = delivered acquisition cost
P.V. = net present value
T
i
= training costs in year i
O
i
= operating costs in year i
M
i
= maintenance costs in year i
S
n
= salvage value in year n
13-13
PVA Incorporated into a TCO Analysis
Acquisition Cost =
$120,000
PV Cash Outflows, yrs 1 - 6 =
23,279
PV of overhaul in yr 3 =
5,208
PV of salvage value in year 6 =
(2,512)
TCO =
$145,975
13-14
PVA Formulas
•
PV
Annuity
= CF [ 1/r – 1/r(1+r)
t
]
»
CF = periodic cash inflow or outflow (must be the same each period)
»
r = discount rate per period (annual rate divided by the number of periods in one
year)
»
t = total number of periods
•
PV = FV / (1 + r)
t
»
FV = future value of single cash inflow or outflow
»
r = discount rate per period (annual rate divided by the number of periods in one
year)
»
t = total number of periods
13-15
Importance of TCO in Supply Management
•
Service Providers
•
Retail
•
Manufacturing
•
Supply Chains/Supply Networks
13-16
Service and Retail Providers
•
Understanding what drives the cost of overhead expenditures is crucial to any
service business
•
Revenue must cover the direct costs, material and labor, and overhead in order to
generate a profit
»
TCO analysis of recurring material costs are often overlooked and can yield great savings
»
TCO analysis of the labor base can reap lower per person costs, greater benefits, and improved
morale
»
TCO analysis of equipment purchases may help reduce the expenditures for maintenance and
parts over the lives of the investments
13-17
Manufacturing
•
Manufacturers are concerned with all of the same TCO issues as service
and retail firms, with some added issues
•
Issues that are particularly important in cost analysis for manufacturers
are:
»
Direct materials
»
Manufacturing overhead
•
Emphasis should be placed on the variance between “should cost” and
actual cost.
»
This should not be confused with price variance
13-18
Activity Based Costing
•
A major problem in TCO analysis of manufacturers is accurate allocation of
manufacturing overhead
•
Many manufacturers have used activity-based costing to help improve cost
allocation
•
Activity-based costing (ABC) is a technique for accumulating cost for a given cost
object that represents the total and true economic resources required or consumed
by the object
13-19
Supply Chain/Supply Networks
•
TCO analysis may include the study
of:
»
Manufacturability
»
Infrastructure
»
Outsource decision
»
Analysis of suppliers beyond tier one
»
Structure of foreign and domestic
tariffs/duties/taxes
»
Costs of delivery
»
Foreign regulations
»
Foreign political/economic stability
»
Foreign exchange risk
»
Language/communication requirements
»
Volatility of end-customer demand
»
Inventory carrying costs
»
Inventory risk
»
Quality costs
13-20
Concluding Remarks
•
TCO is an analytical tool and a philosophy
•
Accurate estimation of total costs requires a cross-functional approach
•
Supply management is a critical member of such a cross-functional
approach
•
TCO is also applicable in one’s private life enabling better decision-
making
13-21
END