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Total Cost of Ownership (TCO)

Total Cost of Ownership (TCO) is a concept that helps manufacturing companies determine the actual cost of an investment decision. Traditionally, the focus has always been on price as deciding how much an acquisition will cost. However, this can be misleading, as this expense typically represents only 60% to 70% of the actual cost. Purchases are often influenced by other “incidental” costs that may seem small at first glance but usually add up. Besides, there are often accompanying indirect costs and considerations that can continually add to the purchase cost, resulting in a much higher expense than anticipated.

The total cost of ownership (TCO) helps companies avoid the frustration of unexpected expenses by estimating all direct and indirect costs of the purchase. It goes beyond the purchase price and takes into account the total financial obligations associated with an investment. In this way, companies can better manage costs, allocate resources efficiently and identify cost drivers early on. 

TCO: the sum of the parts

Total Cost of Ownership (TCO) is a method for estimating the cost components of investment. Direct and indirect costs are included in the calculation so that immediate and future costs are considered. In addition to the procurement cost, the associated costs for the investment’s use and disposal are included. 

Procurement:

  • What is the purchase price? 
  • Is training required, and what is the cost?
  • Are there additional set-up costs? 

Utilization: 

  • What are the costs of usage? 
  • How high are the personnel costs? 
  • Are operating and auxiliary materials required? 
  • How many energy costs will incur for the use? 
  • Is planned maintenance necessary, and how high are these maintenance costs?

Disposal

Are there costs for the removal of the product? 

What measures are necessary for disposal, and how high are the respective costs? 

The analysis of the individual components and TCO calculation thus reveals the direct and indirect costs. It helps identify cost drivers at an early stage and determine the full scope of the investment. 

Why is the TCO calculation necessary?

TCO is an essential tool because it helps buyers know exactly how much money they will pay to purchase a product or service. The method is primarily relevant for buying products that may require maintenance and have a complex purchase decision. These include software, machinery, and tools that may need follow-up or supplemental services. Companies use the method primarily because it is critical for business units to identify the costs incurred to purchase goods and services to account for expenses and calculate profits and losses. TCO can be explained using the example of the car. When buying the vehicle, the costs are due at the time of acquisition as the negotiated price. Incidental charges arise when the car is registered. Ongoing costs for use arise from insurance, wear, tears, services, fuel consumption, etc. The product must be disposed of at the end of the product life cycle. The scrap dealer charges a fee for the disposal. This example shows that the methods can also help private individuals to decide whether to buy an item or not. Since resources are generally scarce or limited, individuals need to understand the total cost of a product or service before making the actual purchase. Some purchases can seem affordable, only to find that the total cost is much higher than what can be afforded. Therefore, by determining the total cost of owning a product or service upfront, the tool plays an essential role in the purchase decision.

Approaches to looking at TCO 

Economists emphasize the importance of looking beyond the price of purchasing an item and analyzing transaction costs. Transaction costs are primarily the basis for TCO analysis, although the analysis can also be applied to make-or-buy decisions. Transaction costs vary by vendor. Therefore, it is vital to analyze them to identify the best value proposition based on buyer requirements and preferences. Two approaches can be used in determining TCO, the dollar-based approach and the value-based approach. The former method collects and distributes actual cost data for the various elements of the total cost of ownership. For example, assume that the total cost of ownership per unit of a particular product is $35; the dollar-based approach looks at a breakdown of the various individual costs that go into the analysis and add up to $35. Such costs can include transportation costs, inspection costs, delay costs, and delivery costs. Furthermore, the value-based approach combines costs with data and other data related to its performance, which is often difficult to express in monetary terms. The method reads the qualities that cannot be valued in financial terms by assigning scores that are then used to determine a particular supplier’s suitability compared to other suppliers.

Identify hidden costs

When purchasing a product, the initial price paid to acquire the product is well known to an individual or company purchasing it. However, other functional costs associated with investing in a particular product or service are usually unknown. In some cases, a product’s price may represent only a small portion of the total cost of ownership. Furthermore, a substantial part of the cost of product ownership is hidden. TCO costing helps identify the hidden costs by making them visible. The hidden costs can be direct or indirect. The direct costs can be identified by assigning them to specific products. For example, in the case of an information technology investment, direct costs may include:

  • Hardware and software purchases.
  • Maintenance and service contract prices.
  • Administrative costs.
  • Employee training costs.

They are costs directly associated with an investment.

How do indirect costs arise?

Indirect costs have a significant influence on maintaining the functionality of the purchased products. Indirect hidden costs arise from the inefficient use of the purchased item. It is complex to identify and quantify indirect hidden costs due to the inefficient use of an object. 

Cost Consideration 

Using TCO is especially important for business units when making purchasing decisions. Businesses are working with a limited budget and therefore need to make the best purchasing decision that will pay off in the end. Therefore, a breakdown of the costs associated with acquiring and maintaining ownership of a product is essential. In other cases, the analysis also helps make make-or-buy decisions. Sometimes it may be cost-effective for a company to manufacture a product rather than buy it or vice versa. Determining the best option is made possible by performing a TCO analysis.

Conclusion

Total Cost of Ownership broadens the perspective and includes other factors besides the purchase price in the analysis. It gives a company the necessary overview of how high the costs are. In addition to this cost analysis, the added value of a solution should be included and considered in the purchasing decision process. Thus, the TCO calculation forms a helpful basis, supplemented by the added value consideration of the individual solutions. 

How do indirect costs arise?

Indirect costs have a significant influence on maintaining the functionality of the purchased products. Indirect hidden costs arise from the inefficient use of the purchased item. It is complex to identify and quantify indirect hidden costs due to the inefficient use of an object.