Total cost of ownership (TCO) is an assessment of all costs involved with an item over its useful life and that of the products into which it goes. Many cost factors are visible to others in the organization but not to supply management. The most complete analysis is compiled by a team that includes supply management, in addition to technical and quality staff and manufacturing. All involved parties should have a chance to include their issues.

The Ground Rules

Start by defining the ground rules and assumptions, including:

·       Definition of the suppliers, the items, and where they are used

·       Estimate of how long the items will be in use

·       Assumptions for quantities or usage rate

·       Identification of the areas of cost to be included

·       Definitions of the formulas for calculating costs

Typically, TCO data is used to make selection decisions for suppliers or items.
It compares Supplier A to Supplier B or Item X to Item Y. These are relative comparisons. Estimates are acceptable as long as they are relatively valid. Two criteria are important in calculating relative costs:

·       The formula makes sense. It is relevant to the issue and can be calculated.

·       The formula can be applied across suppliers and used to validly differentiate them.

Categories of Ownership

Ownership costs can be divided into three categories: cost factors, performance factors, and policy factors. Cost factors are in dollars and can be calculated with reasonable accuracy. They include freight, discounts, and surcharges such as setup costs.

Performance factors include delivery and quality performance and leadtime. Performance factors are relative. As long as the data is valid for comparison, it is less important that it be an absolutely accurate cost.

Policy factors include any issue that reflects business or social policy directives, such as recycled content of materials, minority- and women-owned suppliers, and consensual reciprocity. These factors are yes/no factors. Typically, a supplier or an item either does or does not meet the policy criterion. Establishing a dollar value for these factors rests with the policy makers in your organization.

To create a fair comparison between suppliers or items, both credits and costs should be included. If a supplier offers something of value, then the "cost" of that should be calculated and subtracted from its TCO calculations.

Defining Inventory

Typically, inventory items are of low-to-moderate dollar value per unit but purchased in high volume. Inventory items also are moving through the business. They are being regularly turned over. Typical areas included in the total cost of ownership for inventory are:

·       Cost of non-delivery

·       Cost of non-quality

·       Cost of freight and packaging

·       Availability/flexibility/leadtime

·       Cost of carrying inventory

·       Production-related costs

·       Administration costs per part number

·       Technical assistance

Cost of Non-delivery

If a supplier delivers early, you pay for the items sooner and carry the inventory longer. If a supplier delivers late, you consume people time to replan the production schedule and/or expedite the delivery. If lateness is chronic, you may carry safety stock. A simple method to calculate a relative cost of non-delivery is to use the non-delivery performance percentage as a price adder. For example, if Supplier A delivers on time 85 percent of the time, then it is not on time 15 percent of the time. Multiply its quoted price by 15 percent and add that amount to the base price as a cost factor for non-delivery. The better the delivery performance, the lower the cost factor.

Cost of Non-Quality

This includes the overhead expense of incoming-materials inspection and reject-materials stockroom, the administrative expense of materials review, and the work involved with returns. It also includes quality fallout or rework in production due to defective materials. If you use activity-based costing, then the cost of quality may be an identified cost pool. If so, you may know what those costs actually are, and you can apply those numbers in TCO calculations.

Without actual cost numbers, use the measure of percent defective components as a price adder. For example, if 8 percent of Supplier B抯 material is rejected, then its price is multiplied by 0.08 and that amount is added to the base price to compensate for your costs of handling non-quality goods. The higher the supplier抯 quality, the lower the cost factor.

If you pay freight or packaging costs, these should be included in TCO calculations. For freight, obtain the invoice amounts (from either the supplier抯 or the carrier抯 invoices) for several typical shipments. Add these costs and divide the total dollars by the total number of units shipped. This is the average transportation cost per unit.

Ask suppliers if there are any packaging costs in their quotations. You may want to pull them out and list them separately so they keep their identity. Packaging costs may be an area for cost reduction in negotiations.

Inventory is Expensive

Inventory carrying cost becomes a significant factor in TCO calculations when new item numbers are added or when choice of supplier will have different inventory implications (such as a choice between a domestic supplier and an international supplier or between any two suppliers with significantly different leadtimes). To include inventory costs in TCO, determine your annual cost to carry inventory (percentage). Multiply the price of the item by that percentage. This is the carrying cost per unit per year. Multiply that number by the average number of units in inventory to determine the total dollars of carrying cost per year. To amortize the carrying cost over the total quantity purchased, divide the total dollars of carrying cost per year by the total quantity purchased per year.

Production-Related Costs

Production-related costs include ease of assembly, effect on final product yield, ability to automate, and any other measurable effect that the item has on the manufacturing process. Time factors (i.e., assembly time) can be translated into a total cost factor by multiplying the difference in time between the alternatives by the labor rate used to establish product cost. The cost difference can be applied to TCO. Differences in product yield can be costed by calculating the dollar value of the lost products.

Balancing Organizational Values

The use of a formal TCO process to select and measure suppliers places clearly defined emphasis on performance and policy issues as well as price and allows supply management to easily balance them. The process of defining cost factors will force the organization to become clear about what it values. By giving everyone in your organization access to the process, other functions that have a vested interest in the supply base can state their concerns and define appropriate ways to represent them.

Unit Total Cost Calculation Example