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Chapter 3

TOTAL COST OF OWNERSHIP (TCO)

DOSEN : IR. HOETOMO LEMBITO, MBA, CSLP

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Objektif Perkuliahan

• Memahami konsep TCO

• Memahami fungsi TCO dalam SCM

• Memahami keterkaitan konsep TCO dengan aktivitas purchasing management

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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)

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Key Concepts

• Purchase Price: But One Component of Cost

• The Importance of Total Cost of Ownership in Supply Management

» Service Providers

» Retail

» Manufacturing

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Key Concepts

• Three Components of Total Cost

» Acquisition Costs

» Ownerships Costs

» Post-Ownership Costs

• TCO, Net Present Value Analysis (NPV), and Estimated Costs

• Supply Management Action

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Total Cost and WCSM

• To achieve World Class Supply ManagementSM, managers must shift their focus in procuring materials, services and equipment from price to total cost.

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Importance of TCO

• Service Providers

• Retail

• Manufacturing

• Supply Chains/Supply Networks

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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

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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

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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

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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

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Three Components of Total Cost

• Acquisition Costs

• Ownerships Costs

• Post-Ownership Costs

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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

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Acquisition Costs

• Purchase Price

• Planning Costs

• Quality Costs

• Taxes

» Customs Duties and Tariffs

» Regional Trade Agreements

» Income-Base Shifting

• Financing Costs

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Ownership Costs

• Downtime Costs

• Risk Costs

• Cycle Time Costs

• Conversion Costs

• Non-Value Added Costs

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Ownership Costs

• Supply Chain Costs

» Forecasting

» Administration

» Transportation

» Inventory

» Manufacturing

» Customer service

» Supplier selection/relationships

» Global sourcing

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Post - Ownership Costs

• Environmental Costs

• Warranty Costs

• Product Liability Costs

• Customer Dissatisfaction Costs

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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

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Major Categories for the Components of TCO

Pretransaction Components• Identifying need• Investigating sources• Qualifying sources• Adding supplier to internal

systems• Educating:

» Supplier ins firm’s operations

» Firm in supplier’s operations

Source: Lisa Ellram, “Total Cost of Ownership: Elements and Implementation,” International Journal of Purchasingand Materials Management, Winter 1993.

Transaction Components• Price• Order

placement/preparation• Delivery/transportation• Tariffs/duties• Billing/payment• Inspection• Return of parts• Follow-up and correction

Posttransaction Components• Line fallout• Defective finished goods

rejected before sale• Field failures• Repair/replacement in field• Customer

goodwill/reputation of firm• Cost of repair parts• Cost of maintenance and

repairs

Total Cost of Ownership

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Tangential Reprographics Example

Required rate of return 20.00%

Year NOW 1 2 3 4 5 6Present 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)

Net Present Value Analysis - CopierRequired rate of return 20.00%

Year NOW 1 2 3 4 5 6Present 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)

Net Present Value Analysis - Copier

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TCO Formula

nTCO = A + P.V. (Ti + Oi + Mi – Sn)

i = 1

A = delivered acquisition costP.V. = net present value Ti = training costs in year i Oi = operating costs in year i Mi = maintenance costs in year i Sn = salvage value in year n

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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

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PVA Formulas

• PVAnnuity = 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

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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