Ellram, Siferd 1993

JOURNAL OF BUSINESS LOGISTICS. Vol.14. No. 1, 1993 163

PURCHASING: THE CORNERSTONE OF THETOTAL COST OF OWNERSHIP CONCEPT

by

Lisa M. Ellramand

Sue Perrott SiferdArizona State Univeristy

The total cost concept has been a popular topic in business school curriculain the past decade. In purchasing, the total cost concept also is referred to as thetotal cost of ownership or life cycle costing.' Purchasing textbooks from 1928ând perhaps even earlier discuss the importance of considering cost related issuesbeyond price in choosing a supplier. Yet relatively little progress has been madein integrating the total cost concept into supplier selection and supply basemanagement.

What is the total cost of a purchasing decision made today? Before 1980,most American firms would answer that question by looking at the bottom lineof a supply contract. A common criterion for selecting suppliers was to choosethe lowest bidder. Conventional wisdom in U.S. firms dictated that a desire forlow cost take precedence over quality. Acceptance of a relatively high defect ratewas accompanied by a willingness to carry extra inventory. Inventory managers,expediters, and inspectors were very busy on shop and factory floors. Supplierswere pitted against each other, since the threat of losing a contract to a competitorwas thought to be the best way to "keep a supplier in line." Buyers and supplierstypically had an adversarial relationship. Thus cooperation between buyer and sellerwas not only uncommon, but in some situations it could be considered illegal bylessening competition.

In the early 1980s, attitudes began a shift that has resulted in a 180 degreetum. The "total cost of ownership" has now become a concept of great importance.Firms throughout the world know that they must no longer trade low cost to achievehigh quality. They know that higher quality results when workers are empoweredto inspect and correct their own work. They know that supplier coof)eration can

164 ELLRAM AND SIFERD

result in long-term payoffs. While firms can show that quality has improved andcycle time, labor content, and inventory levels have been reduced, few have learnedhow to measure the bottom line effect of such improvements. Indeed, ManufacturingControl and Performance'^ documents many cases in which remarkable improvementsin quality and productivity actually appeared to result in higher costs. Could itbe that conventional wisdom of choosing the lowest price supplier was right afterall? The authors think not! The authors agree with Kaplan's premise: "modem"cost accounting is the villain!-^ Thus, this paper will examine the total cost conceptas an altemative to conventional cost accounting practices, which assign costs basedon labor hours, machine hours, or other arbitrarily determined bases.

The purpose of this article is fourfold. First, this paper will explain what thetotal cost of ownership (TCO) concept entails, and how the TCO concept has evolved.Second, the benefits of adopting a TCO perspective will be discussed. Next, wewill explore, on a limited basis, the magnitude of the adoption of the TCO conceptin purchasing practice, and how and where that TCO concept could be used inthe purchasing function. Finally, this paper will discuss what steps need to be takenin order to implement a TCO approach that is workable within the purchasingfunction.

THE TOTAL COST OF OWNERSHIP PERSPECTIVE DEFINED

The TCO concept requires firms to consider the activities they undertake thatcause them to incur costs. By analyzing fiows and activities within each process,a firm can identify which activities add value, and which do not. Further, a firmcan determine explicitly which activities it performs and pays for intemally, versusactivities perfonned by others that increase the price of purchased goods or services.Thus, a firm can identify the true cost of any activity, rather than simply the costsallocated or paid extemally for that activity.^

The TCO implies that all costs associated with the acquisition, use, andmaintenance of an item be considered in evaluating that item and not just thepurchase price. However, costs are often lumped together and allocated based onproduction units, direct labor hours, or some other factor, rather than based strictlyon the relationship between the cost and activities performed. In product costing,the TCO concept has been used to assign storage, labor, and other costs basedon activities involved rather than on a predetermined formula. The TCO is part

JOURNAL OF BUSINESS LOGISTICS, Vol.14. No. I. 1993 165

of the total cost concept. A model relating key purchasing activities to the TCOconcept is shown in Figure 1. Key purchasing activities have been divided intosix major categories. Figure I also includes examples of activities in each category.

Methods of Measuring/Assigning Costs

Costs incurred by the fimi can be viewed in a number of ways. For example,costs can be viewed as direct versus indirect, or variable versus fixed. The definitionsof variable versus fixed cost and direct versus indirect cost are based on the waythe costs behave in relation to some activity over a given time period. Traditionaldefinitions of these cost terms are shown in Table 1. These are conventions thathave been used for years in accounting, and for assigning costs. Most fjeople donot think of costs in terms of whether they are direct or indirect. People understandthat if a particular activity is performed, there will be a cost associated with thatactivity. Thus, activity-based costing is a practical starting point for understandingand analyzing costs.

History of the Total Cost of Ownership Concept

The TCO perspective is not a new concept; it has been discussed and practicedin some form for many years.^ Harriman pointed out that "the science of buyingis recognizing...the longer range factors of fitness, interchangeability, renewals,replacements, general maintenance, wearing qualities, and cost per unit of utility."Unfortunately, the paper systems for tracking costs that existed in most firms throughthe 1960s prevented purchasing from obtaining data on the above cost categoriesby purchased item. Costs are often summarized and allocated. When firms beganto implement computerized accounting and record keeping, the existing manualsystems were simply automated. There was limited or no attention given to changingthe previous manual allocation processes to refiect costs incurred by activity. Extemalreporting needs, such as accounting for inventory costs, work-in-process, and costof goods sold, drove the accounting system. Limited attention was given to theinformation needs of intemal managers.

The purchasing function has long been aware that some suppliers provide betterservice and are easier to do business with, thereby reducing the finn's intemalefforts and expenditures. However, there has been no systematic way of determiningand measuring those costs. Purchasing managers who are interested in determining


FKiURE 1

PURCHASING ACTIVITIES CONTRIBUTING TOTHE TOTAL COST OF OWNERSHIP

QUALITYÂclivilies related lo (

Select and approveAssess supplier performanceUndcrsiand suppliers' priKesscMaintain supplier relationsAcijuit^ parts for reworkRetum rejected pansInspect incoming materialsDispose of scrap

MANAGEMENTActivities related to Matiagemcnt

Determination of purchasing strategy inconjunction with corporate strategy

tlire. evaluate, promote, fire purchasingpersonnel

C\x)rdinate with other functionsTraining of purchasing personnel

Initial orient:ition(ingoing procedure changesProfessional development

DKLIVERVActivities related to Delivery'^

Accept deliveryAccept partial shipmentBxpedite late ordersArrange for correction ofincorrect orders

PRICEActivities related to Price

Negotiate terms of contractwith respect to:

quantityqualitydelivery conditionsfreight costspurchase discountscontract lengthdegree of ccx>rdinationyand cix>peration

roiAi- c().sTOI' OWNERSHIP

COMMLMCATIONSAclisilies related lo( ummunicationsUpdate forecasts andcommunicate to suppliers

lêpare and send purchase order:hv mail, phone, fax. and electronicdata interchange

Maintenance of purchasinginformation system

Match purchase orders with receiptsMake invoice adjustmentsBill back retumed itemsMaintain inventory records

SERVICEActivities related to Service

Oversee installation of equipmentOversee maintenanceOrder pans for warranty repairsInvolvement in customer traininiMaintain spare pans inventoryfor nonwarranty repairs

Supply service manualsConduct product recallsRespond to complaints

ineral trouble shooting

JOURNAL OF BUSINESS LOGISTICS. Vol.14, No. I, 1993 167

TABLE 1

TRADITIONAL COST CLASSIFICATION TERMS

Tetrn

Fixed Cost

Variable Cost

Semi-variableCost

Direct Cost

Indirect Cost

Relevant Cost

Traditional Definition

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

A cost that varies in directproportion to some activitylevel.

A cost that contains both fixedand variable elements. Forexample, it may increase inincrements, or steps, rather thandirectly with volume.

A cost, variable, fixed, or semi-variable, that can be directlyattributed to some activity.

A cost, variable, fixed or semi-variable, that supports activities,but cannot be directly traced toany given activity. For example,factory lighting allows a numberof activities to take place in thefactory.

A cost that changes, dependingon the activity or decisionmade.

Problem

Costs that are not truly fixedmay be arbitrarily lumped andallocated.

Time frame determines whethera cost is truly ftxed.

Costs are often assigned thewrong activity base. Forexample they are allocated onvolume when it should bemachine hours.

Variable costs may be pooledand allocated, when they shouldbe directly assigned based onactivity.

Same problems as variable cost.

A variable cost may beimproperly classified assemi-variable due to lack ofunderstanding of what drivesthe cost.



Costs that are not fixed may bearbitrarily lumped and allocated.

Costs may not be as "indirect"as they first seem, and ananalysis could tie them directlyto an activity.

Lack of understanding or datacauses firms to improperlyoverlook some relevant costs asunchanging with differentaitematives.


such costs frequently are told that this type of infonnation is unavailable, doesnot exist, or is only available on an aggregate basis.

Infonnation on all costs must exi.st at some point, or they would never getinto the computer system. For example, if materials shortages shut down a productionline, and the line employees are still paid, the firm will experience an unfavorabledirect labor variance. That unfavorable variance may be allocated to all productsthat were in production that day, week, or month. Yet that unfavorability was causedby the particular item that was being run on that particular line. Further, evenif the unfavorability was allocated back to that product, the unfavorability wasnot due to direct labor, but rather to a materials shortage. Is it not logical to changethat unfavorability against that material.' Further, if the shortage was due to poorsupplier perfonnance, should not the excess costs associated with the shortage becharged against the cost of that material from that supplier, so that the firm hasa valid record of the cause of the shortage? Such an expense is truly a cost ofdoing business with that particular supplier for that particular item.

However, in most firms, the variance would appear as a direct labor variance.It would take a great deal of work and retracing of steps to determine what preciselyhad caused that variance in a year, a month, or perhaps even a week after theshortage occurred. The true cost of doing business with a particular supplier isthus lost in the accounting system of the firm. As is frequently observed, payingthe supplier a lower price may increase the total cost of ownership, particularlyin areas such as delivery reliability, quality, and after sale service support.

Little work has been done to provide those in the purchasing area with a logicaland consistent way to gather cost data on attributes beyond price. Further, littlework has been done that discusses which attributes are important to measure insource selection and/or evaluation.

BENEFITS OF USING A TOTAL COSTOF OWNERSHIP APPROACH

There are several key benefits to using the TCO approach. First, the TCOapproach is logical and easy to understand. Second, the TCO approach brings thetotal cost of an item into perspective, so that an improved supplier selection decisioncan be made. Good supplier selection is critical given the high dollar expendituresof many firms on purchased goods and services. Third, information gained through

JOURNAL OF BUSINESS LOGISTICS. Vol.14. No. I. 1993 169

the TCO model can provide important data for analyzing, negotiating, and reducingthe total cost of purchasing an item.

First, as discussed in the preceding section, the TCO model attempts to simplifythe TCO approach by grouping cost components into related categories the sameway in which costs are incurred. The TCO approach is a logical, activity-basedmethod of analysis. The categorization by activity should make costs easier tounderstand and recognize, as well as collect. By separating intemal cost informationby activity, the true cost of a particular activity is easier to discern. Thus, costfigures can be used with confidence and understanding in decision making. Elaboratetnanipulation and re-creation should not be required to use intemal cost informationfor decision making.

Second, while some costs directly related to a particular material (e.g., scraplosses, reject, and rework) are charged to the product using that material, manycosts (e.g., expediting and invoicing problems) are not. Unfortunately, such costsare often considered to be indirect or administrative costs. Consequently, such costsare not allocated directly to the items to which they were related. These costsinstead become part of a pool of costs that may be allocated among all products,based on product volume, direct labor, machine hours, or other allocation bases.Thus true costs are distorted, and poor supplier selection decisions may be made.

Poor decisions can be very costly to the firm. The costs that firms incur forpurchased goods and services as a percentage of sales are high in many industries.In 1987, 53.8% of the sales price of manufactured goods was made up of purchasedgoods and services. For illustration, purchased goods as a percentage of the costof goods sold was 76.3% in the non-ferrous industry, 60% in the transportationindustry, and 55.1% for the paper products industry.^ Thus, as one would expect,price paid for purchased goods and services receives a great deal of attention inmany industries. However, cost information is often incomplete because of the focuson price rather than the TCO and consequences of purchasing decisions.

Third, related to an improved understanding and selection of suppliers, theTCO approach is a useful analysis, negotiation, and cost reduction tool. For example,the level of service a firm provides can have a significant impact on the cost ofdoing business with that supplier. A firm may monitor receipts versus open orders,and know what percentage of orders are shipped complete and accurate. However,few fimis actually monitor how much it costs them when an incomplete orderis received. The costs might include follow-up on the problem, expediting, higher

/ 70 ELLRA MAND SIFERD

freight from two smaller shipments, duplicate paper work, and changing the scheduleto accommodate the shortage.

All of the preceding activities are disruptive, costly, and time-consuming tothe firm. All costs are incurred specifically in doing business with a particularsupplier. Thus, they should be added to the cost of materials which that supplierprovides. More meaningful comparisons of the total cost of doing business witha supplier are thus available.

In addition, a better understanding of the various cost components throughoutthe purchasing cycle can provide a basis for negotiation with a supplier. A firmthat can document the costs of supplier service can use that infonnation as leverageto secure an offsetting price reduction or improved service. The same cost informationmay be u.sed to justify a redesign of the product or service so that the currentsupplier can provide better service or so that the firm can switch to a differentsupplier.

Complete TCO information can also provide an important basis for analysisof opportunities to reduce cost. If late shipments are relatively more costly to thebuyer than incomplete shipments, the fimi can request that shipments not be heldup until the order can be completely filled. Thus, cost reduction opportunities canbe uncovered and pursued more readily with the complete infonnation providedin the TCO approach to purchasing. The buyer needs a model with readily availablecost information so that such decisions can be made quickly and intelligently.

USAGE OF THE TOTAL COST OF OWNERSHIP APPROACH

The usage of a TCO approach in purchasing is limited in actual practice. Arecent survey explored the use of cost savings and analysis tools among randomlyselected members of the National Association of Purchasing Management (NAPM).Of 521 surveys mailed, 114 usable surveys were retumed. yielding a response rateof approximately 25%. The survey asked high-level purchasing directors,vice-presidents, and managers about their perception of the TCO approach versusother analytical tools used in purchasing. Eighty-five percent of survey respondentsindicated that they were familiar with the TCO approach. Sixty-nine percent ofrespondents indicated that they would be comfortable either using or interpretingthe results from a TCO approach model. However, it was felt that the TCO approach

JOURNAL OF BUSINESS LOGISTICS. Vol.14. No. 1. 1993 171

received less top management emphasis and attention than most altemative analysistechniques, as illustrated in Table 2."'

TABLE 2

PERCEIVED TOP MANAGEMENT EMPHASISOF FINANCIAL TECHNIQUES*

Retum on Assets - ROA

Payback - PB

Retum on Equity - ROE

Intemal Rate of Retum - IRR

Net Present Value - NPV

Discounted Payback - DPB

Total Cost - TCA

Value Analysis - VA

Relative Rank**

1

2

3

4

56***

6***

8

* Survey respondents representing the purchasing function ranked thetechniques in order of their emphasis by

** Rank where 1 is the most emphasized or

*** Represents a tie in ranking.

n = 114

top management.

frequently used.

While this information is interesting, it is also helpful to know how manyfinns are actually using a TCO approach in purchasing goods and services. Toexpand upon the above survey and address that question, one of the researchersconducted two informal, non-random surveys. In the first survey, a group ofapproximately 120 persons from the Purchasing Management Association of Arizonawho attended the April 1991 dinner meeting were asked to indicate whether theirfirm used a TCO model. Representatives from only one firm indicated that theyhave a TCO model in place.

/ 72 ELLRAM AND SIFERD

The second test of the prevalence of a TCO model was at the 76th AnnualNAPM Intemational Conference and Exhibit in San Francisco in May of 1991.Persons attending a presentation discussing purchasing cost savings were askedto complete a short survey on the use of the TCO approach. Given their interestin purchasing cost savings and their attendance at such a conference, it is assumedthat those responding to this survey would be more progressive in their costingapproaches than the average purchasing function.

There were 103 people who completed the survey. As shown in Table 3, only18% of respondents have a formalized TCO approach for evaluating purchaseditems. While 25% definitely do not have a TCO model, approximately 58% indicatethat they use an informal TCO approach to evaluate purchased items. Oneinterpretation of these facts is that the purchasing function considers cost issuesbeyond price in decision making. However, the lack of a formalized approach cancreate inconsistencies in comparing the costs among suppliers as well asinconsistencies among purcha.ses. Without a formal approach, it is difficult andtime consuming to determine cost figures. Such difficulties create inaccuracy andharm credibility. As indicated by the first survey cited, the purchasing functionmay feel relatively comfortable with the TCO approach. However, top managementdoes not appear to have given such an approach much emphasis, partly due toinaccurate data and lack of a formalized model. In tum, purchasing does not fullyimplement the TCO approach because of lack of top management attention, andlack of data availability."

As a first step, purchasing must identify the cost data needed to support theTCO approach. The required data must then be made readily available in a usableformat. Such a task is no small matter. Historical cost accounting tradition is onebarrier. However, many firms are breaking down that barrier. An additional barrieris lack of attention and understanding by the purchasing function of the key costelements that should be part of the TCO model. These and other issues relatedto implementation are discussed in the next section.

Cost Ratio Model

A variation on the TCO model that has received the most attention m thepurchasing literature is the cost-ratio approach. The cost-ratio model generally limitsinvestigation of cost factors to include price, the costs associated with quality, and

JOURNAL OF BUSINESS LOGISTICS. Vol.14, No. 1. 1993 173

costs associated with delivery. '^ '^ Clearly, TCO approaches encompass many

additional factors, as we have illustrated in Figure 1.

TABLE 3

USE OF TOTAL COST OF OWNERSHIPIN EVALUATING PURCHASES

Response

Unsure

Yes, Formal Model

Yes, Informal Model

No

Total

N = 103

Percentage Responding

0

18%

58%

24%

100%

As a result of the lack of hard data, purchasing's cost analysis is based onprice and items actually tracked by the firm, such as rework costs. There is likelyto be a "gut feel" for how the supplier performs in other areas, with little substantiveevidence. "Gut feel" is subject to the recency affect, where one tends to rememberand weight heavily the most recent experience with a particular supplier. Mostrecent behavior may or may not be relevant, depending on what factors have causedthe behavior. To detemiine the total cost associated with doing business with aparticular supplier, for a particular item, the cost factors contributing to the "gutfeel" about the supplier must be identified and quantified. This information doesexist, but some detective work and painful data collection may be necessary toestablish it. For example, buyers may need to start logging time spent expeditingand following up on problems. This time would then be charged against the materialit related to, at least in purchasing records. These logs could give purchasing abetter feel for the true TCO of dealing with a particular supplier.


Zero Base Pricing Model

Another variation of the TCO approach is Polaroid's Zero Base Pricing Model. ''*Zero Base Pricing looks at two major cost components: the purchase or acquisitionprice and the in-house costs. The in-house costs include those expenses the buyingfirm incurs in addition to the purchase price, in using the seller's product. Suchcosts include customer returns, lost sales, inbound transport, scrap, rework, yieldloss and associated productivity losses, production, storage, and inspection. Thegoal of Zero Ba.se Pricing is to reduce the TCO. Zero Base Pricing dictates thatall components of cost must be looked at in terms of what Burt et al."'' defineas controllable and non-controllable elements. Z^ro Base Pricing further requiresthat the buying finn's entire product design and manufacturing process be scrutinized.Thus, Zero Base Pricing goes beyond the purchasing function to include otherfunctional areas of the finn.

Similar to Zero Base Pricing, the TCO approach requires that a firm lookat all of the costs it incurs in purchasing a specific item from a specific supplier.These costs go beyond purchase price to include quality associated costs such asrework, inspection, delays; delivery associated costs such as timeliness, completeness,and lead time required; communications costs such as EDI and paper flow; andservice-associated costs such as expediting due to poor delivery, follow-up on qualityproblems, and incorrect invoicing; and management costs of training, technologytransfer and similar issues. As noted earlier in the paper, a diagram of this proposedmodel is shown in Figure 1. This model indicates a broad spectrum of some ofthe many costs of ownership. Not all costs would apply to ail situations. Further,additional costs may be imponant in some cases.

The major difference between the TCO approach and zero base pricing is thatthe TCO approach focuses on understanding and tracking those costs that are incurredby the buying firm. Zero Base Pricing is inherently proactive, focusing more heavilyon working with the supplier to reduce and manage TCO. As a firm begins tobuild a TCO model, the infonnation gathered will lead them to work with intemalcustomers and suppliers more effectively.

IMPLEMENTATION

Implementation of the TCO approach in purchasing begins with an understandingof the costs that affect a purchased item. While detennining the type of costs to

JOURNAL OF BUSINESS LOGISTICS, VoL 14, No.l, 1993 175

include in the TCO approach is not difficult, certain costs are easy to overlook.The best way to avoid ignoring cost components is by diagramming the entireacquisition process, from the request of an item by the user, all the way throughany returns or follow-up on credits, defective items, and invoicing problems.

A Flowchart of Purchasing Activities

Table 4 shows the formal activities that are typically found in a purchasingcycle. Also included in Table 4 are some examples of support activities that frequentlymust be performed in order to accomplish formal activities at each step. Manyof these activities are included in Figure 1. Neither of these presentations areconsidered to be all inclusive. Their purpose is to be representative of activitiesin which purchasing organizations engage.

In focusing on an analysis of both formal and support activities, an organizationcan understand which activities add value and which do not. In order to analyzethe cost of these activities, it is essential to identify the inputs, processes, andoutputs for each activity. An analysis of the flows of information, paper, employees,materials, and even customers through each activity is sure to uncover somenonessential steps that are currently being perfonned. A careful study of the resultingflowcharts will often lead to knowledge of which steps can be combined or eliminated.It is suggested that for time-consuming steps in each process or activity a firmshould determine the reason for the performance of that step. There is nothingmore fruitless than making an activity more efficient when the activity does notneed to be perfonned at all.

One of the important inputs to many of the processes involved in the purchasingfunction is likely to be the time of purchasing professionals and other employees.It may be necessary to perform a work sampling study in order to get a roughestimate of how much time is spent on various activities. Work sampling is a usefultechnique for providing estimates of how professional employees spend their time.For an explanation of how to design a work sampling study, see Krajewski andRitzman.'* An analysis is not complete without making an effort to identify theunderlying factors that drive the amount of time spent on an activity. In somecases there may be primary and secondary drivers. For example, time spent expeditingorders for the factory may be attributed to poor supplier performance on delivery,which may be due to poor initial communications with the supplier regarding deliveryrequirements. It is important to note here that the buyer should not assume that


TABLE 4

FORMAL AND SUPPORT ACTIVITIES IN ATYPICAL PURCHASING CYCLE

Formal Aclivities*

Purchase RequisitionIssued

Item is formally requestedby user after receipt ofrequired approvals

Support Activities**

Need for item arises

Check inventory records

Research for possiblesuppliers

Check for availability ofitem

Confirm user requirementsas to delivery date.quality, price

Solicit price quotes, bids.or proposals

Receive and open bids inprescribed fashion

Hold meetings withsuppliers

Visit supplier sites

Select and approvesuppliers

Conduct negotiations

Interact with legal.financial, and accountingpersonnel as required

Possible Cost Drivers***

Item complexity

Item scarcity

Item price

Volume required

Frequency of purchase

Uniqueness ot itemLegal requirements

Organization requirements

Location - yours andsupplier's

Familiarity with supplier

Number of suppliers

JOURNAL OF BUSINESS LOGISTICS, Vol.14, No.l, 1993 177

TABLE 4 (Continued)

Formal Activities*

Purchase Order Issued

Order is formally placed

Formal notification to:SupplierUserAccounts PayableReceiving DepartmentInventory Management

(Note that no formalaccounting system entryhas yet been made.)

Order ConflrmationReceived

Supplier confirms receiptsand acceptance of order

Order confirmation is filedwith copies of purchaseorder


Data physically enteredinto purchasing system:manually, electronically,or other

Coaection of any errorsnoted by user orsupplier

Phone calls and othercommunication maybe required if timelynotification is notreceived

Need for changes inquantity, delivery date,or item specificationsarises


TVpe of purchasingsystems - yours andsupplier's

Care taken in orderplacement

Training of purchasingpersonnel

Order complexity

Type of purchasingcontract such as:One time purchase orderBlanket purchase orderStanding purchase orderOther cooperative

arrangement

TVpe of purchasingsystems

Order complexity

Sophistication of supplier

Degree of cooperationbetween your firm andsupplier

Forecast uncertainty

Production scheduleinstability

F^duct cannot bemanufactured as designed

178 ElMRAM AND SIFERD

TABLE 4 (Continued)

Formal Activities*

Change Order Issued

Engineering change orderto product specificationsissued

Request for change indelivery date or quantityreceived

Purchase OrderAmendment Issued

Issue a formal revisionto the original purchaseorder

Notify the same partiesas in issuance of theoriginal


Many phone calls andother correspondencemay result

Renegotiating withsupplier regardingprice and other terms

Confirmation of newterms with user

Check legal and financiaiimplications

May have legal andfinancial complicationsrequiring interactionwith other departments

Requires more input lothe system, updatingrecords and tiles

Follow-up with necessaryphone calls, meetings.and communications

Investigation andexpediting of lost orlate orders


Complexity of the change

Type of change

Frequency of this sort ofrequest to supplier

Supplier unreliabilityInability of supplier to

forecast well

Complexity of the change

Number of items involved

Type of change

Impact of the change onschedules, costs.customer orders

JOURNAL OF BUSINESS LOGISTICS, Vol.14, No.l, 1993 179

TABLE 4 (Continued)

Formal Activities*

Receipt of Order

Order is received, andformally documentedwith a receiving report

Receiving report notes anydiscrepancies betweenreceipt and order

Determine quality ofincoming shipment

Payment made to carrier

Formal entries to theinventory system mustbe made

Payment for the Items

Payment is madeaccording to the termsof the agreement withthe supplier

Accounts Payable makesthe appropriate accountingentries and authorizesissuance of the check forpayment of the invoice


Resolution ofdiscrepancies betweenreceipt and order

Damaged items returned

Damage claims filedwith carrier

Billing adjustmentsnegotiated

Receiving ref)ort filed

Purchasing system andother records updated

Arrangements for check,cash or money orderfor transportation

Receipt of invoice fromsupplier

Receipt of item may needvertification

Correct billing errors

Correct payment errors

Update files


Complexity of order

Reliability of supplier

Reliability of carrier

Delivery date of orderrelative to due date

Delivery arrangementwith supplier

Large lotsPartial ordersSmall "just-in-time"deliveries

"Dock-to-stock"arrangements

Design of accountingsystem

Degree of internalcontrol over paymentauthorizations

Reliability of supplier

Agreement with supplier


TABLE 4 (Continued)

Formal Activities*

Item is used InProduction

A formal entry is made tothe inventory systemcharging productionwith the item

Repairs Under Warranty

Cost of repair results inentries to the accountingsystem


Resolution of anydissatisfaction with theitem by the user

Updated approves supplierlists

Order may be placed forspare parts using theusual purcha.se ordersystem

Make spare part supplierdecisions


Product design

Supplier reliability

Purchasing strategy

Supplier approval process

Production strategy

Product complexity

Product design

Product reliability

* Formal activities are defined as resulting in paperwork or an entry to theformal purchasing or materials management system.

** Suppt)rt activities are all the activities that cau.se to occur or support formalactivities, and consume purchasing resources.

*** Cost drivers are characteristics of the products or processes that may berelated to the level of resources consumed by the activities.

the costs of dealing with different suppliers are the satne. Indeed, the cost of placitig

ati order or followitig up on a problem may be quite different among suppliers,

depending upon how user friendly their systems are. Thus, a sampling of several

suppliers should be made to detemiine which costs of doing business differ among

suppliers.

JOURNAL OF BUSINESS LOGISTICS. Vol.14, No.l, 1993 181

It is helpful to know all costs of a particular purchase for developing a trueTCO. TCO analysis may provide opportunities for cost reduction and avoidancethat are general to that purchase, rather than related to a specific item or supplier.It should be noted that when a cost is identified that is the same for all itemsand suppliers, knowledge of the magnitude of that cost should not affect the selectionof a particular supplier or item. Thus, for supplier selection, the focus should beon costs that differ.

Conceptualizing the Total Cost of Ownership

Figure 1 and Table 4 can be used as a starting point for analyzing the firm'sTCO issues from a purchasing perspective. The issues to include should be modifiedfor the particular situation. Once the activities have been identified, the purchasingmanager should spearhead an effort to determine:

1. Which activities consume the most time?

2. What are the costs of these activities?

3. What drives the level of these costs?

4. For which costs is infonnation readily available?

Purchasing can begin to develop a TCO model based on available cost information.The use of predetermined overhead figures is to be avoided. Purchasing may notbe aware of all the detailed cost data currently available. Thus, the purchasingmanager should seek the cooperation of the controller to determine how knowncost information has been computed and what information is available for TCOanalysis. Frequently, microcomputers can aid the purchasing function in gatheringcost data without relying on support from the accounting function. If limitedinfonnation is available, the focus initially should be on getting information forthe costs that are relevant to decision making, for the costs that appear to be thelargest, and for the costs that are most readily estimated. As previously mentioned,a work sampling study, conducted entirely within the purchasing function, can leadto estimates of time spent on various activities.

To implement a TCO model fully, the cooperation of upper management andthe accounting function is essential. In some firms, where the computerized costingand accounting system is set up in a flexible manner, it will be relatively easyto obtain much of the detailed cost information required to support the TCO approach.It may only be a matter of defining needs, refining the way cost information is

/«2 ELLRAM AND SIFERD

classified in the computer system, and getting a repon put together to access andsummarize the data automatically.

In many firms, a major overhaul of the computerized costing system will berequired. In most cases, any modifications to the system to support a TCO modelneed not affect anyone else's reponing, although other functions should be encouragedto subscribe to a TCO approach. Cooperation and suppon from production andinventory control, logistics, and customer service will strengthen the case formodifying the cost reporting system. Because of the key role of the purchasingfunction in obtaining inputs to the finn's processes, purchasing must take the initiativein obtaining interfunctional suppon for use of a TCO model.

Major Systems Modiflcation

If it appears that a major modification of the current costing system, or thedevelopment of an entire new program, will be required to develop a TCO approach,top management support is clearly needed. Before approaching top management,purchasing management should be fully prepared to present information on theimportance of the TCO approach, and on the benefits that will accrue to the firm.If preliminary studies lead to estimates of cost savings, it is an excellent idea topresent such data. The benefits will have to be weighed against the costs of modifyingthe system. Further, the interest and suppt)n of other functional areas within theftrm will strengthen the case for modification.

If suppon is lacking, or such a system does not appear to be cost beneficialat the current time, purchasing should let it be known that they desire such informationin the future. When system modifications or upgrades are made, purchasing wouldlike their request to be considered a.s pan of (he change. It is often more economicalto make several changes simultaneously. However, purchasing should track thosecosts for which they have information on a microcomputer-based system and continueto develop its own analyses.

SUMMARY

Until such time as the TCO approach can be fully implemented, purchasingshould consider whatever cost data is available in analyzing sourcing aitemativesand in making operations more efficient. By focusing on activities and associatedcost drivers, purchasing can identify the goods and services that provide the firm

JOURNALOF BUSINESS LOGISTICS, Vol.14, No.l. 1993 183

with the lowest total cost of ownership. Because purchasing activities affect ailareas of the TCO, purchasing has a vested interest in taking the lead in designing,implementing, and utilizing such a model. The key benefit of implementing a TCOapproach is improved supplier selection decisions. Given the magnitude of purchasedcost for many firms, the TCO approach can make a significant contribution.

The TCO approach represents a progressive, systematic approach tounderstanding, analyzing, managing, and reducing the total cost of ownership ofmaterials, services, capital goods, or any purchased item. The TCO approach supportsfunctional integration and communication from the design stage onward, as wellas cooperation and communication between the buying and supplying firms. Suchintegration and communication provides the best understanding and infonnationto support the TCO approach. The total cost of ownership is one critical part oftotal cost analysis for a firm. Because of the significant portion of expense accountedfor by purchased goods and services, no cost analysis is complete without acomprehensive understanding of the firm's TCO. Thus, the TCO approach representsan important way for the purchasing function to improve its performance andcontribute to the competitiveness of the firm.

Author's note: The first author acknowledges support for this research fromArizona State University's faculty-grant-in-aid program.

NOTES

'Michiel R. Leenders, Harold E. Fearon, and Wilbur B. England, Purchasingand Materials Management, 9th ed. (Homewood, 111.: Irwin Publishing, 1989).

^Norman F. Harriman, Principles of Scientific Purchasing, 1st ed. (New York:McGraw-Hill, 1928).

^Same reference as Note 1.

''Robert S. Kaplan, ed.. Measures for Manufacturing Excellence (Boston: HarvardBusiness School Press, 1990).

''Same reference as Note 4.


^Michael R. Ostrenga, "Activities: The Focal Point of Total Cost Management,"Management Accounting 71 (February 1990): 42-49.

^H. Thomas Johnson and Robert S. Kaplan, Relevance Lost: The Rise andFall of Management Accounting (Boston: Harvard Business School Press, 1987).

*'Same reference as Note 2, at p. 21.

''jim Morgan, "The Leverage Behind Every Purchasing Pro," Purchasing 27(October 1988): 21.

'"Lisa M. Ellram, "The Role of the Purchasing Function in Purchasing CostSavings Analysis," International Journal of Purchasing and Materials Management,28 (Winter 1992): 26-33.

"Same reference as Note 10.

'^Same reference as Note 1.

'Êd Timmerman, "An Approach to Supplier Perfonnance Evaluation," you/oa/of Purchasing and Materials Management 22 (Winter 1986): 2-8.

'•'David N. Burt, Warren E. Norquist. and Jimmy Anklesaria, Zf/v? Base Pricing(Chicago, III.: Probus Publishing, 1990).

'•''Same reference as Note 14.

'^Lee J. Krajewski and Larry P. Ritzman, Operations Management, Strategyand Analysis. 2nd ed. (Reading, Mass.: Addison Wesley Publishing Company, 1990).

ABOUT THE AUTHORS

Lisa M. Ellram received her Ph.D. in logistics from Ohio State University.She is an assistant professor of purchasing and logistics management at ArizonaState Universily. Her current research interests include the total cost of ownership,intemational supply chain management, and buyer-seller relationships.

Sue Perrott Siferd received her Ph.D. in operations management from OhioState University. She is an assistant professor of operations management at ArizonaState University. Her current research interests include activity based costing,work-force flexibility, and the productivity of service functions in both themanufacturing and service sectors.

Documents

Ellram, Siferd 1993