Why is it important to provide computer owners with an idea of the total cost of ownership rather than just having them look at the purchase price?

Total cost of ownership (TCO) is a financial estimate intended to help buyers and owners to determine the direct and indirect costs of a product or system. It is a management accounting concept that can be used in full cost accounting or even ecological economics where it includes social costs.

For manufacturing, as TCO is typically compared with doing business overseas, it goes beyond the initial manufacturing cycle time and cost to make parts. TCO includes a variety of cost of doing business items, for example, ship and re-ship, and opportunity costs, while it also considers incentives developed for an alternative approach. Incentives and other variables include tax credits, common language, expedited delivery, and customer-oriented supplier visits.

Total Cost of Ownership (TCO) is a calculation designed to help people make more informed financial decisions. Rather than just looking at the purchase price of an object, TCO looks at the complete cost from purchase to disposal. It adds to the initial purchase price other costs expected to be incurred during the life of the product, such as service, repair, and insurance. TCO is factored into cost benefit analysis.

Total Cost of Ownership (TCO) is the single most important principle in all of supply chain management. It quantifies and measures costs. The principle of TCO has impacted commercial negotiations by expanding the narrow confines of Price to a vast field of opportunities for attaining Win-Win results. Anyone can get a lower price. The object of good business is to attain the lowest TCO. 

In professional purchasing, we can reduce the essence of everything that we do to a single word – Cost. Any discipline falling under the umbrella of Supply Chain Management can be interpreted and expressed in terms of Cost. Value and cost are related in that the Best Value means the lowest TCO. 

Many business execs carelessly confuse the concepts of price and cost, using them interchangeably. To define them simply, price is the money coming in, cost is the money going out and profit is the difference. Profit is the remainder after subtracting cost from price. For this reason, cost management is crucial to business success. For two companies selling at competitive prices, the higher cost company realizes lower profits. Basic economics show that high costs are bad for business. 

Supply chain management personnel can facilitate the TCO analysis by combining their broad-based analytical skills with those of other team members to ensure that all relevant costs are considered. A brief examination of each type of business together with supply management’s vision and role in minimising total costs is a good place to begin.

Service Providers

Service firms provide “intangible” products to satisfy human wants and needs. Service providers run the gamut from the accounting, legal, and medical professions to federal, state, and local governments to window washers, gardeners, and taxi drivers. Service providers procure capital equipment, products, and services as well as hire employees and provide employee benefits such as health and life insurance. Like all businesses,service firms enhance profitability by increasing sales at a faster rate than costs, maintaining sales and reducing costs, or increasing sales and reducing costs, while maintaining the desired quality and timeliness. Understanding what drives the cost of overhead expenditures is crucial to any service business. Service revenue must cover the direct costs,material and labor,and overhead in order to generate a profit. 

An important consideration in service businesses, as well as in retail and manufacturing, is the total cost of maintaining the employee base. Paying the lowest wage does not necessarily result in the best employee. The cost of getting a new and inexperienced employee “up to speed” can be high, and the learning curve may be long. Paying more for an experienced person with a short “ramp up” time may be the best long-run solution for a given position. A total cost/total benefit analysis of company-sponsored health insurance programs can reap rewards in terms of lower per person total costs, greater benefits for covered employees, and improved morale.

Retail

The considerations that apply to service businesses also apply to retailers. Retail businesses sell a product that often must be ordered,received,inventoried,sold,and perhaps, delivered to the customer. The choice of a system that facilitates the processes involved in inventory ordering and turnover will influence the total cost of inventory ownership. Many major retailers have empowered select suppliers to manage their product inventory for them, thus reducing purchasing overhead and inventory carrying costs without necessarily increasing the product cost. Embracing the Just-in-Time (JIT) philosophy is another way to improve QCT (quality, cost, and time) while reducing TCO. Lowering the cost of goods sold and the overhead costs associated with procurement, inventory carrying costs,and sales improve the bottom line. It is often easier to lower costs than to increase sales in a competitive business environment. 

Manufacturing

Manufacturing businesses are concerned with the same TCO issues as are service and retail firms. In addition, they procure direct materials (raw materials, products, sub assemblies,etc.) and incur overhead in the production of their finished goods inventory and other activities required to conduct business. Managerial accountants place emphasis on the variance between what something “should cost”or is expected to cost and what it actually costs. 

The accurate allocation of manufacturing overhead is a major factor in calculating the true unit cost of a product. Using the wrong cost driver (the process or activity that creates the need for overhead) can make a product seem more or less expensive than it actually is. Activity Based Costing (ABC),although initially somewhat complicated and expensive to implement, can return long-run benefits by providing more accurate unit cost information that serves as the basis for better decisions. Careful budgeting and procurement of overhead items, from the purchase of capital equipment to lubricants used in production,and the implementation of systems to ensure the timely availability of accurate information are methods used in obtaining the lowest total cost of production.

Supply Chains/Supply Networks

A supply chain is a set of three or more entities (organizations or individuals) directly involved in the upstream and downstream flows of products, services, finances, and/or information from a source to a customer. A supply network is a less linear, more flexible virtual system linked by advanced communication systems and enhanced supplier alliances. A supply management professional/organization can apply the philosophy and practice of TCO to the strategic optimization of costs within the chain or network. For example, an American company with the option of making a new product in Asia (potentially lower manufacturing costs) and shipping it to their customer base in the United States (higher transportation costs) or manufacturing it in the United States (potentially higher manufacturing costs) with minimal shipping (lower transportation costs) will have to determine the total cost of each alternative before making a decision.

To sum up TCO is an analytical tool and a philosophy that supports management decision-making. A supply management professional can modify the TCO approach to support each major purchase decision, as well as integrate it into strategic cost analysis to support make or buy (outsourcing), pricing and costing, critical direct material purchases, and other decisions that require analysis of costs over time.

TCO is also a powerful adjunct—for example,in evaluating employee benefit programs and aiding in analyses such as the total cost of implementing an integrated activity based costing system in a manufacturing business. Estimates are the basis of most ownership and post-ownership costs. The care with which a supply management professional, in a cross-functional team, estimates these costs will determine the effectiveness of the resulting analysis.

As a philosophy,TCO can become an active part of everyday decision-making. For example,TCO can help a family determine the total costs of maintaining a pet or choosing kitchen appliances. If the expression “There are no free lunches” is true, then everything we do has a tangible or intangible cost that can be analyzed if necessary.

It is necessary to spend money to get new infrastructure items, products, or systems to optimize business results.

However, it is not always easy to perceive the actual amount of money needed for the acquisition. That’s why companies should be aware of the total cost of ownership (TCO).

Managers must analyze this metric before every new acquisition to make an accurate decision. Better detailing of costs helps you keep finances under control and have greater predictability about an asset’s life cycle.

Each company’s area must adopt this dynamic, ensuring that the investments are wise and generate a good long-term cost-benefit ratio.

In this article, we will discuss in detail the concept of TCO and how to use it. Below, you will find the following topics:

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What is Total Cost of Ownership?

The total cost of ownership (TCO) is a metric that measures the amount of money spent on acquiring any asset.

This calculation is based not only on the purchase price but also on the amount of money spent from a long-term perspective.

Therefore, we can understand that the TCO measures the cost of acquisition, maintenance, and operation of a given asset.

The total cost of ownership is a crucial metric for decision-making. Before making an investment or a purchase, calculating the TCO can bring better economic predictability.

Companies are concerned about the amounts spent on acquisitions because they need to make safe investments.

Indeed, high initial spendings are not always the most serious difficulty. A specific asset’s cost often tends to grow in the long term, and this situation can generate an unexpected expense.

If haven’t done so and want to start an LLC or any other type of company, you might want to include the costs of incorporation and other aspects into your TCO calculations as it is an investment into the future of your business.

When to Use TCO?

TCO is useful whenever a company aims to acquire an asset or make a large investment. The metric could be relevant in situations such as:

• Purchasing new computers and other tech devices.
• Renting a new office.
• Purchasing facilities for the company’s headquarters.
• Hiring a new management system.
• Purchasing a marketing tool.

Every asset that has an extended lifetime tends to generate additional costs.

Software, for example, needs a renewal of licenses and requires the company to have a budget for training so that employees know how to operate them.

New facilities for the company’s headquarters, in turn, generate infrastructure maintenance costs. They don’t embrace just the purchasing, but also operational expenses so that everything works fine.

By calculating the total cost of ownership, it’s easier to estimate all these additional expenditures generated over the long term. Thus, numbers are the basis of an investment choice.

How to Calculate the TCO?

The TCO calculation considers some implicit values. An asset has a price, but, besides this cost, many other factors will impact the amount of money spent.

You can make two calculations: a simple one and another more complex. The use of each one depends on the context and what you intend to acquire.

The simplest calculation considers three factors:

• initial cost (I)
• maintenance cost (M)
• remaining costs (R)

Thus, the calculation will be:

I + M – R = TCO

The initial cost is the label price, that is, how much you will pay for the asset. 

The maintenance cost, in turn, involves the costs to ensure that the asset remains useful in the long term.

The remaining cost is the asset’s price in the long term, for example, in five years. This last factor helps us make a calculation focused on a possible devaluation.

The other calculation method embraces more factors when considering the asset’s total cost.

It is important to include more variables since, most of the time, many factors impact the acquisition cost if we consider a long-term perspective.

In this case, the factors are:

• initial cost (I)
• operation cost (O)
• maintenance cost (M)
• downtime cost (D)
• production cost (P)
• remaining value (R)

Thus, the calculation will be:

I + O + M + D + P – R = TCO

How Can Different Areas Use TCO?

Different departments within a company may use the TCO before making an acquisition decision. Let’s understand this better below!

Marketing

The marketing department has to spend its budget regularly. Acquiring automation, analysis, and collaborative management tools are the main types of expenses in this sector.

In these investments, it is essential to analyze factors that generate costs, such as:

• Licenses.
• The monthly cost of the plan.
• The costs of training employees to prepare them to operate the software.
• The acquisition of new software if the chosen one gets discontinued.

Accounting

Accounting is a department that needs to participate in the acquisition decision process, along with several other sectors.

This area can analyze additional fees, taxes, and other expenses that a purchase may generate, both at the time of the acquisition and in the future.

Management

Management is responsible for managing purchase orders for equipment and infrastructure-related goods.

This department usually purchases computers, office supplies, and tools in general. It can even participate in acquiring a new business office.

Management must always use TCO before making any purchase decision.

Challenges with Calculating TCO

Although there are many methods and helpful tools out there that make it easier to accurately calculate the total cost of ownership, it’s still not necessarily an exact science. 

The challenges involved include the following.

Operating cost scope is hard to determine

This can especially be the case when acquiring assets like tech equipment. 

Not only are there many hidden costs involved that are easily overlooked, but many companies fail to compare the correct products when assessing probable TCO.

Some costs are near impossible to predict

While some factors that affect the total cost of ownership are easy to anticipate because they’re so common, there will always be additional costs you can’t predict at all. 

For example, unforeseen distributor charges could mean a specific replacement part you’ll need down the line suddenly skyrockets in price.

It’s difficult to calculate the benefits involved

When you only look at TCO when deciding whether to pull the trigger on a purchase, you’re simply not seeing the whole picture. 

It’s much harder to put a price on the benefits of acquiring the asset in question, but they should be considered, too.

TCO Example

Want a closer look at how the total cost of ownership works within a business context? 

Let’s use a hypothetical IT business as an example.

Let’s say this business is looking for a way to manage its databases more efficiently and is considering a server system upgrade as a means of doing this. 

Naturally, the business’s purchase team will take a close look at all the available options on the market that could meet the company’s needs.

However, assessing the total cost of ownership will mean looking well beyond the initial price. For instance, one server option might have a great price tag but call for expensive upgrades within the next few years or require extensive additional training for in-house IT personnel.

Another option might represent more of an investment up-front but be more cost-effective and business budget-friendly to maintain over the long haul. 

If it also requires little to no additional team training to get it up and running, then it’s likely the wiser purchase even though the initial price is higher.

What to Consider while Building a TCO calculator?

A company must have a tool to calculate the total cost of ownership.

It is necessary to consider some important standards while developing a calculator, which will ensure an accurate result.

Always consider that:

• The calculator should have as many factors as possible to allow the user to find the total cost.
• The calculator must consider the asset’s life cycle — the price it will have in a few years.
• When developing the calculator, you must consider your business’ market and its characteristics.

Wrap Up

The total cost of ownership is a metric that every company should use to ensure better asset and finance management.

Achieving an optimized cost-benefit ratio when investing is only possible if each cost involved in the acquisition and maintenance is known correctly.

You should find a developer or a tool to create a TCO calculator that considers your customer’s business’s essential factors. Therefore, get to know Ion, the perfect platform to help your company with that!