The Importance of Total Cost of Ownership (TCO) in Supply Management

The Importance of Total Cost of Ownership (TCO) in Supply Management

The Importance of Total Cost of Ownership (TCO) in Supply Management
  The Importance of Total Cost of Ownership (TCO) in Supply Management
 

 
Total cost of ownership (TCO) is a financial estimate intended to help buyers and owners to determine the 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, and opportunity costs, while it also considers incentives developed for an alternative approach. Incentives and other variables include tax credits, common language, expedited delivery, and customer-oriented supplier visits. 

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Total Cost of Ownership (TCO) is a calculation designed to help people make more informed financial decisions. Rather than just looking at the purchase price of an object, TCO looks at the complete cost from purchase to disposal. It adds to the initial purchase price other costs expected to be incurred during the life of the product, such as service, repair, and insurance. TCO is factored into cost benefit analysis.
Total Cost of Ownership (TCO) is the single most important principle in all of supply chain management. It quantifies and measures costs. The principle of TCO has impacted commercial negotiations by expanding the narrow confines of Price to a vast field of opportunities for attaining Win-Win results. Anyone can get a lower price. The object of good business is to attain the lowest TCO.  
 
In professional purchasing, we can reduce the essence of everything that we do to a single word – Cost. Any discipline falling under the umbrella of Supply Chain Management can be interpreted and expressed in terms of Cost. Value and cost are related in that the Best Value means the lowest TCO. 
 
Many business execs carelessly confuse the concepts of price and cost, using them interchangeably. To define them simply, price is the money coming in, cost is the money going out and profit is the difference. Profit is the remainder after subtracting cost from price. For this reason, cost management is crucial to business success. For two companies selling at competitive prices, the higher cost company realizes lower profits. Basic economics show that high costs are bad for business. 
Supply chain management personnel can facilitate the TCO analysis by combining their broad-based analytical skills with those of other team members to ensure that all relevant costs are considered. A brief examination of each type of business together with supply management’s vision and role in minimising total costs is a good place to begin.
 

Service Providers

Service firms provide “intangible” products to satisfy human wants and needs. Service providers run the gamut from the accounting, legal, and medical professions to federal, state, and local governments to window washers, gardeners, and taxi drivers. Service providers procure capital equipment, products, and services as well as hire employees and provide employee benefits such as health and life insurance. Like all businesses,service firms enhance profitability by increasing sales at a faster rate than costs, maintaining sales and reducing costs, or increasing sales and reducing costs, while maintaining the desired quality and timeliness. Understanding what drives the cost of overhead expenditures is crucial to any service business. Service revenue must cover the direct costs,material and labor,and overhead in order to generate a profit.  

An important consideration in service businesses, as well as in retail and manufacturing, is the total cost of maintaining the employee base. Paying the lowest wage does not necessarily result in the best employee. The cost of getting a new and inexperienced employee “up to speed” can be high, and the learning curve may be long. Paying more for an experienced person with a short “ramp up” time may be the best long-run solution for a given position. A total cost/total benefit analysis of company-sponsored health insurance programs can reap rewards in terms of lower per person total costs, greater benefits for covered employees, and improved morale.

Retail  

The considerations that apply to service businesses also apply to retailers. Retail businesses sell a product that often must be ordered,received,inventoried,sold,and perhaps, delivered to the customer. The choice of a system that facilitates the processes involved in inventory ordering and turnover will influence the total cost of inventory ownership. Many major retailers have empowered select suppliers to manage their product inventory for them, thus reducing purchasing overhead and inventory carrying costs without necessarily increasing the product cost. Embracing the Just-in-Time (JIT) philosophy is another way to improve QCT (quality, cost, and time) while reducing TCO. Lowering the cost of goods sold and the overhead costs associated with procurement, inventory carrying costs,and sales improve the bottom line. It is often easier to lower costs than to increase sales in a competitive business environment. 

Manufacturing  

Manufacturing businesses are concerned with the same TCO issues as are service and retail firms. In addition, they procure direct materials (raw materials, products, sub assemblies,etc.) and incur overhead in the production of their finished goods inventory and other activities required to conduct business. Managerial accountants place emphasis on the variance between what something “should cost”or is expected to cost and what it actually costs. 

The accurate allocation of manufacturing overhead is a major factor in calculating the true unit cost of a product. Using the wrong cost driver (the process or activity that creates the need for overhead) can make a product seem more or less expensive than it actually is. Activity Based Costing (ABC),although initially somewhat complicated and expensive to implement, can return long-run benefits by providing more accurate unit cost information that serves as the basis for better decisions. Careful budgeting and procurement of overhead items, from the purchase of capital equipment to lubricants used in production,and the implementation of systems to ensure the timely availability of accurate information are methods used in obtaining the lowest total cost of production.

Supply Chains/Supply Networks  

A supply chain is a set of three or more entities (organizations or individuals) directly involved in the upstream and downstream flows of products, services, finances, and/or information from a source to a customer. A supply network is a less linear, more flexible virtual system linked by advanced communication systems and enhanced supplier alliances. A supply management professional/organization can apply the philosophy and practice of TCO to the strategic optimization of costs within the chain or network. 
 
For example, an American company with the option of making a new product in Asia (potentially lower manufacturing costs) and shipping it to their customer base in the United States (higher transportation costs) or manufacturing it in the United States (potentially higher manufacturing costs) with minimal shipping (lower transportation costs) will have to determine the total cost of each alternative before making a decision.

To sum up TCO is an analytical tool and a philosophy that supports management decision-making. A supply management professional can modify the TCO approach to support each major purchase decision, as well as integrate it into strategic cost analysis to support make or buy (outsourcing), pricing and costing, critical direct material purchases, and other decisions that require analysis of costs over time. 
TCO is also a powerful adjunct—for example,in evaluating employee benefit programs and aiding in analyses such as the total cost of implementing an integrated activity based costing system in a manufacturing business. Estimates are the basis of most ownership and post-ownership costs. The care with which a supply management professional, in a cross-functional team, estimates these costs will determine the effectiveness of the resulting analysis. 

As a philosophy,TCO can become an active part of everyday decision-making. For example,TCO can help a family determine the total costs of maintaining a pet or choosing kitchen appliances. If the expression “There are no free lunches” is true, then everything we do has a tangible or intangible cost that can be analyzed if necessary. 

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The Author: Ranjan Sinha

                                    Ranjan Sinha
About:
CEO | Logistics | Supply Chain Automation | Shipping | Import Export | Steel | Port Operations | Management ConsultingIBlockchainITransportation 
A strategic leader of multi-cultural experience in spearheading entire strategic business operations such as shipping, logistics,  supply chain planning & port operations across India, UAE, Qatar, Oman & Eastern Europe with key contributions in providing advisory & consultancy in optimizing & rationalizing manufacturing processes & supply chain networks, driving productivity, cost reduction, internal process & customer service improvement projects in collaboration with key decision makers.   Excellence in import & export operations,  S&OP/IBP, Demand & Supply Planning, 3PL & 4PL services, procurement & vendor management, sales & business development, change management, SAP & new system implementation.   Exhibited leadership in transforming business, 
 
making high-stakes decisions using sound & experienced based judgment, formulating business strategies, augmenting EBITDA & gross margins, increasing customer retention rates, implementing Quality Management Systems-ISO 9001:2000, SAP R/3-Sales & Distribution Module & end-to-end 4PL project. Capable of formulating and implementing the business development & growth strategy in global SCM, restructuring operations and introducing important measures to bring in profitability, executing concessionaire agreement between Public Private enterprises especially Public-Private Partnership, Built-Own-Operate-Transfer models including issuance of RFP packages, evaluation of proposals and writing contract award recommendations.   Well-travelled across Middle East, Europe and CIS countries for interaction with geographically dispersed Logistics/ Supply Chain colleagues/Investors to develop and agree upon generic and targeted knowledge solutions to close identified development gaps within the function.  Currently looking for senior level assignments in Logistics/Supply Chain/Port Operations. Contact : [email protected]

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