March 29, 2023 | Cost Management Blogs
Tracking spend is essential to maintaining profitability. But how can CPOs ensure that their enterprise is getting the best value for money? Enter Total Cost of Ownership (TCO) analysis.
Total Cost of Ownership is a methodology in procurement for calculating all the costs associated with a particular purchase over its entire lifecycle. The costs include not only the initial purchase price but also any costs associated with maintenance, repairs, upgrades, and disposal.
Total cost of Ownership in spend analytics provides a comprehensive picture of the true cost of a purchase. This enables enterprises, global or local, to make more informed decisions in terms of sourcing and procurement.
A small example how TCO makes sense to gauge the true cost of purchase could be a scenario where an enterprise needs to procure a new piece of machinery for its production line. Considering two options, the first machine that was shortlisted costs $50,000 upfront and comes with an expected lifespan of approximately 10 years. Now, although the second one costs $75,000 upfront, which is $25,000 more than the first one, it has an expected lifespan of about 15 years.
The first option with a significantly lower price point does seem like the better choice because of its lower upfront cost, at a quick glance. However, when the enterprise has to factor in the cost of maintenance, repairs, and eventual replacement, the lifetime cost goes up significantly, without even factoring the quality aspect.
Therefore, the second option with a better lifespan actually is more cost-effective in the long run.
Calculating TCO could turn out to be a complex process, which is best left to software based TCO calculators. Nevertheless, it would typically involve the following steps:
Identify all the costs, over the entire lifecycle, related to the product, including:
Assign a monetary value to each cost, even if it’s just an estimate.
Sum up all the costs to determine the TCO.
Divide the total cost by the product’s expected lifespan to get the annual cost of ownership.
Compare results of TCO between different options to determine which one offers the best value for money. This can help enterprises to prioritize investments, negotiate better contracts, and select the most suitable vendor or supplier.
Consider the qualitative factors that may affect TCO, such as reliability, performance, user satisfaction, environmental impact, and regulatory compliance — because these factors may not be easily quantifiable, make a significant impact on the total value delivered by the purchase.
Use TCO as a basis for ongoing cost management and optimization. By tracking the actual costs incurred and comparing them to the estimated TCO, organizations can identify opportunities for cost reduction, process improvement, or innovation.
Communicate the TCO results and implications to stakeholders, such as executives, managers, users, and suppliers. This can help to build consensus, align expectations, and foster accountability for cost-effective decision-making.
Review and update the TCO analysis periodically, especially when new information or changes in the environment occur. This can help to ensure that the TCO remains relevant and accurate, and that decisions are based on the most up-to-date information available.
Once the total cost or the Total Cost of Ownership for the purchases is calculated, an enterprise can use this information to make better procurement decisions. Analyzing the data and comparing the TCO for different options makes it a lot easier to choose the option that will provide the best value for money over the long term.
TCO analysis can also help enterprises identify additional areas for cost reduction. For example, if the maintenance costs are particularly high for a particular equipment, an enterprise could consider switching to a different supplier or consider investing in equipment with better specifications that will require less maintenance.
TCO analysis can help enterprises negotiate better contracts with suppliers. Armed with data on the true cost of ownership, enterprises can enter negotiations with a stronger bargaining edge and negotiate more favorable terms.
All said, enterprises should keep in mind that TCO analysis is not a one-time event. As the business evolves and the needs change, the TCO too needs to be re-evaluated for all purchases to ensure that the enterprise continues to get the best value for money.
Total Cost of Ownership or TCO is an essential analytical tool for enterprises that want to make informed procurement decisions. Calculating the total cost of a purchased product over its entire lifecycle gives a more complete picture of the true cost, enabling better decisions that will benefit the company in the long run.