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) Three Components of Total Cost Acquisition Costs Ownerships Costs Post-Ownership Costs Purchase Price: But One Component of Cost TCO, Net Present Value Analysis (NPV), and Estimated Costs The Importance of Total Cost of Ownership in Supply Management Service Providers Retail Manufacturing

1. Chapter 13
Total Cost of
Ownership
13-1

2. 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)
13-2

3. Key Concepts
• Three Components of Total Cost
» Acquisition Costs
» Ownerships Costs
» Post-Ownership Costs
• Purchase Price: But One Component of
Cost
13-3

4. 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

5. Three Components of Total Cost
• Acquisition Costs
• Ownerships Costs
• Post-Ownership Costs
13-5

6. 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
13-6

7. Acquisition Costs
• Purchase Price
• Planning Costs
• Quality Costs
• Taxes
» Customs Duties and Tariffs
» Regional Trade Agreements
» Income-Base Shifting
• Financing Costs
13-7

8. Ownership Costs
• Downtime Costs
• Risk Costs
• Cycle Time Costs
• Conversion Costs
• Non-Value Added Costs
• Supply Chain Costs
13-8

9. Ownership Costs
• Supply Chain Costs
» Forecasting
» Administration
» Transportation
» Inventory
» Manufacturing
» Customer service
» Supplier selection/relationships
» Global sourcing
13-9

10. Post - Ownership Costs
• Environmental Costs
• Warranty Costs
• Product Liability Costs
• Customer Dissatisfaction Costs
13-10

11. 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

12. 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
13-12

13. TCO Formula
n
TCO = A + P.V.  (Ti + Oi + Mi – Sn)
i = 1
A = delivered acquisition cost
P.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
13-13

14. 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

15. 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 13-15

16. Importance of TCO in Supply Management
• Service Providers
• Retail
• Manufacturing
• Supply Chains/Supply Networks
13-16

17. 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

18. 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

19. 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

20. 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/communicati
on requirements
» Volatility of end-
customer demand
» Inventory carrying
costs
» Inventory risk
» Quality costs
13-20

21. 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