May 2, 2013 1 Comment
Buyers everywhere face pressure to deliver cost savings. The problem is that too many eyes become focused on stated vendor cost rather than Total Cost of Ownership (TCO or “Tee-Co”). Looking at an invoiced cost only tells part of the story. TCO brings clarity of true comparative economics. The concept is one of leveling the playing field between vendors and vendor origins. It is especially applicable to off-shore and low-cost country supply chain options. It works for goods and services alike.
When is a bargain no longer really a bargain? The short answers lie in typical buyer’s remorse. It’s when the product or service ends up costing a lot more than we than we thought it would , or when it turns out that it really would have been cheaper to buy it elsewhere. The incremental costs remain hidden or otherwise disaggregated.
Understanding True Costs with TCO
Maybe we should have thought things through a bit more, kicked a few more tires, or looked harder for hidden costs before pulling the trigger. As individual consumers, most of us know this feeling all too well, and it’s really no different with larger-scale business purchases. Without discipline and the proper tools, human nature predisposes us to make these same mistakes- only this time with our employers’ money. With higher- volume spends, misinformed buying becomes a higher stakes poker game where no one wants to make the fool’s bet.
The TCO approach offers a way to put alternatives on the same basis by explicitly quantifying costs that were previously hidden or are disaggregated within typical accounting systems. All too often, what we see on the invoice fails to tell the true story. TCO unmasks the Other Relevant Costs of Ownership (ORCO) and allows for greater visibility of inevitable trade-offs.
TCO = Stated Vendor Cost + Other Relevant Costs of Ownership
|TCO for Product:||TCO for Service (Engineering or IT):|
|Stated Vendor Cost per unit||Stated Vendor Cost per unit|
|+ Freight||+ Extra Hours at Stated Vendor Cost per unit|
|+ Customs & Duties||+ Internal Management Time|
|+ Tooling||+ Internal Analysis & Design Time|
|+ Product Lead Time||+ Maintenance & Ongoing Support|
|+ Net Working Capital||+ Net Working Capital|
|= Total Cost of Ownership||= Total Cost of Ownership|
TCO for Products
Usually cheaper labor is the factor that allows a perceived low-cost country (PLCC) vendor to get our attention with a low stated vendor cost. We soon discover that it will cost a small fortune to ship that product at least half way around the world. We also will encounter the added cost of getting the goods out of port on a timely basis. Ocean freight is cheaper than air but can add lead time challenges, which in turn greatly hinder our ability to respond to customer-driven demand changes. If we choose to play a just-in-time game and use air freight, we can expect to pay significant premiums. Tooling costs can also differ greatly, and working capital trade-offs stemming from minimum order quantities (MOQ ‘s) and terms differences also factor into the equation. Taking a few minutes to understand the ORCO can pretty quickly turn our initial stated vendor cost comparisons upside down.
TCO for Services
The TCO service example is best viewed in the cases of Engineering or IT outsourcing to PLCC vendors. Similar to our product example, the allure is in the quoted low cost per hour. It appears to the buyer that the same resource costs a lot less. The key here is to make sure that the resources truly are the same and can perform at the same level. If the resources differ in capability and/or speed, we can expect to foot the bill for an excess of hours to complete the project as well as some potentially significant internal management costs expended to keep things on track. Additionally, supplemental analysis and design support may be required because the PLCC resources lack specific knowledge of our businesses and applications. Resulting design oversights can lead to higher ongoing maintenance and technical support costs. With ORCA quantified, TCO shows us a view that may stand in stark contrast to our initial stated vendor cost comparison.
Toward a Better Tomorrow
TCO is the type of value-added cost analysis technique that screams common sense. Part of the reason that this sense is not as common as it should be is that compensation systems continue to reward the appearance of a bargain. As long as turning short-term tricks still has handsome reward, things are not likely to change quickly. It’s going to take the right incentives to make the right things happen. If more people including some in Washington DC do the math, maybe a few much-needed jobs will return to the US.