No Bargains

BargainsBuyer’s Remorse

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.

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About Thomas W. Smith
Bizsinc - Bringing Business to Life

One Response to No Bargains

  1. Tom, excellent points about a critical issue. As a consultant specializing in helping companies choose optimal locations worldwide for their business facilities, I have seen that many firms tend to overly influenced by “headline” cost factors like labor costs and inclined to ignore (or at least underweight) other, less obvious costs. The models I use to compare location options include all relevant geo-variable costs, as well as qualitative factors that don’t lend themselves to being easily quantified, e.g., political stability, business environment/infrastructure, and the quality, availability and competition for certain labor skill sets, among many others. When making location decisions that will determine if, or to what extent, an investment decision will be cost-effective, companies should evaluate ALL possible variables (and to model, based on realistic assumptions, what the operation’s cost profile will be 10 or 20 years out).

    There is an interesting effort underway called The Reshoring Initiative, founded in 2010. TRI is “an industry-led effort to bring manufacturing jobs back to the United States. The initiative works with U.S. manufacturers to help them recognize their profit potential as well as the critical role they play in strengthening the economy by utilizing local sourcing and production.” A complimentary TCO estimator is available on their site, http://www.reshorenow.org.

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