TOTAL COST OF OWNERSHIP (TCO): EVERYTHING YOU NEED TO KNOW
Multifix’ advisors regularly receive questions about ‘Total cost of ownership’ (TCO), in the article below we try to answer them. Other questions can of course also be answered by them. In the article below, the following topics are discussed:
WHAT IS TCO?
Gartner defines total cost of ownership (TCO) as a comprehensive assessment of the cost of a product or service across enterprise boundaries over time. For example, for IT, TCO includes the purchase of hardware and software, management and support, communication, end user expenses and the costs of downtime, training and productivity losses.
Total Cost of Ownership (TCO) is designed to help consumers and businesses estimate all costs of capital assets. The idea is to get an overview that includes not only the purchase cost, but all aspects of the subsequent use (energy costs, repair and maintenance) of the relevant parts. In this way, known cost items or even hidden costs can possibly be identified before an investment decision is made.
The TCO method was developed in 1987 by Bill Kirwin, Research Director at the management consulting firm Gartner Inc. on behalf of Microsoft. However, the idea of including costs outside the purchase in decisions was already put forward by Ralph Borsodi in 1927.
Numerous models have been published in the literature on TCO (and Life Cycle Costing or LCC, see below). Geissdoerfer et al. compare and evaluate 20 models, the Gartner Group model and the DIN EN 60300-3-3 model received the most points.
A new approach to TCO calculation based on quantitative and qualitative model building blocks and empirical data was presented by Klaus Geissdoerfer. In practice, this approach is flexible and can therefore be applied very time-saving. The model is based on existing models and extensive research into companies that already use TCO or LCC.
To calculate the TCO, a free open source tool has been made available on Sourceforge.
TYPES OF TCO COSTS
To get a good picture of the total cost of ownership of an investment, an overview must be made of both the directly attributable costs and the indirect costs.
Direct costs are not subdivided into cost centers (such as the costs of an employee), but into processes whose costs can in principle be calculated by allocating them to other cost centers. Usually, these costs are incurred in the purchase and maintenance of resources. From a business perspective, direct costs are characterized by their budgetary feasibility. In this way, a sustainable effect of these costs, both positive and negative, on the success of the company can be demonstrated. Direct costs using the example of a PC:
- Purchase costs for hardware and software (depreciation or leasing rates), costs from maintenance contracts with manufacturers or service providers and costs for IT infrastructure (networks, servers).
- All processes in the field of administration and support (operating costs)
- Administrative expenses (e.g. asset management, contract drafting, budget planning), coordination of training measures for IT staff and end users (administration costs)
Indirect costs do not arise from the purchase or guarantee of the operation of capital goods, but from unproductive use by the end user. These are always processes, procedures or situations that impede the end user in his productivity. Since these processes can be different for all end users, the measurability of such a process is fundamentally problematic. However, it is debatable to what extent these costs affect a company’s cash flow, i.e. the cash flow in the form of receipts or payments. According to Krcmar, these indirect or even unbudgeted costs amount to between 23 and 46 percent of the total costs. Indirect costs using the example of a PC:
- Application development: Development of own applications (e.g. Excel tables)
- Data management and desktop configuration (file and data management)
- Non-availability of the system concerned (personnel costs or costs for lost business activities)
- Self-help and occasional training (Casual Learning and Self-Support)
- Training measures to train the end user in a specific application (formal learning)
- Support from another inexperienced user (‘peer support’)
CRITICISM OF THE TCO CONCEPT
The main problem with the TCO model is that it does not indicate the extent to which an improvement in TCO, especially in indirect costs, can actually affect the company’s profits.
Another point of criticism is that the TCO concept does not provide methods to determine the indirect costs resulting from productivity losses. In practice, it should also be clarified whether these costs are actually incurred as a result of the failure of an investment object (e.g. downtime of a server).
Finally, in many cases allocated shares for rent, energy costs, etc. are not taken into account. Moreover, there are currently no significant approaches in the literature or in the trade press to discuss the entrepreneurial risk assessment in relation to the TCO model.
TCO IN INDUSTRY
The TCO consideration in the industrial environment is becoming increasingly important today, due to increasing global competition. For example, machine suppliers in large projects are required to make TCO calculations when submitting their bids, but internal TCO calculations are also becoming increasingly important for smaller machine manufacturers in order to increase efficiency in the company.
An example: A valve terminal is more expensive for a company compared to individual valves in direct cost calculations. However, the company saves money if indirect costs are also taken into account. This is because the time required by the manufacturer for individual valves is many times greater due to the sequence of many individual steps such as searching and configuring, downloading, generating the drill pattern, installing the CAD model in the CAD assembly, creating and releasing the CAD models in the PLM system, and so on. Thus, without the TCO approach, there is less incentive for an industrial company to invest in this, because only this approach shows the potential for optimization and cost reduction.
LIFE CYCLE COSTING
The related terms TCO and Life Cycle Costing (LCC) (or Whole-Life Cost) are often confused and not clearly defined. Simplified LCC is mainly used for capital goods in industry. Transaction costs are of minor importance here, as operating and acquisition costs are many times higher. TCO, on the other hand, is used for smaller purchases (PCs, software), consumables (screws, grease), services, etc.
Life cycle costing (LCC) is a cost management method that takes into account the development of a product from the product idea to its withdrawal from the market (product life cycle), i.e. “from cradle to grave”. Only the negative cash flows (expenses) are important, the revenue (income) is neglected.
The concept of Life Cycle Costing was already applied in the sixties of the last century for large investments in the construction and military sector. In the United States, the concept was used by the U.S. Department of Defense as a decision aid in the procurement of weapon systems. The background to this was that the ministry had carried out an expenditure analysis as a result of budget cuts. This revealed that a significant portion of the expenditure was not for purchases, but for the maintenance and operation of previously purchased systems. This made it clear that not only the purchase costs of the systems, but also the expected follow-up costs of the entire life cycle of the systems are relevant when awarding contracts for the systems and should therefore be taken into account in the decision-making process. Later, the concept of life cycle costs was also used to assess the economic efficiency and design of complex large-scale projects in industrial mechanical engineering.
Life Cycle Costing can be viewed from two different perspectives, from the perspective of the producer or the client.
From the point of view of the producer, both the total own costs and the costs of the customer are determined. Even before production, i.e. during product development, the producer has to consider different options for a product and choose the most favorable one. The customer perspective is also interesting for companies, as it is often neglected despite increasing customer focus. The customer is not interested in the development or production costs, but only in his own costs from purchase to sale. Targeted information can be used to communicate the economic and ecological benefits of the product to the customer.
One way to reduce the operating costs of customers is, for example, a guarantee, which reduces possible repair costs. Return guarantees or recycling options contribute to reducing disposal costs. However, this reduction in the customer’s follow-up costs increases the manufacturer’s follow-up costs. It is necessary to weigh the individual options, which can be based on a joint analysis, for example. The following points can be taken into account:
- Customer perspective
- Training and use
- Manufacturer support
- Producer perspective
- Product development and conception
- Process development
LCC and the Net Present Value
It is often necessary to choose between different options when making a purchase. Life Cycle Costing takes into account not only the purchase costs, but also the operating costs (e.g. operational personnel costs, maintenance costs, energy and consumption costs, …) and the disposal of a product. Contrary to the Net Present Value method, the allocated payments are not discounted to the time of acquisition (present value), but the actual payments are compared on an accrual basis. Only the Net Present Value method allows a holistic view of the product and a choice of the most favourable option for the value in use.
Suppose a consumer has two options when purchasing a product. Option 1 seems at first glance quite cheap, the purchase costs are low. However, if the consumer buys this product, he is faced with high operating and disposal costs. Option 2, on the other hand, makes a rather expensive impression due to the high acquisition costs. However, because of the low follow-up costs, there is a compensation, the so-called trade-off. This trade-off can only be made by looking at the lifecycle. The traditional cost calculation is not able to do this, because of the periodicity. The Net Present Value method not only correctly takes life cycle costs into account, but also their occurrence over time and, by discounting, gives the effects on business value as a decision criterion. It is superior to other methods in terms of maximizing the value in use.
Application of LCC
Especially in the field of ecologically oriented business administration, the LCC method is very popular because of its holistic approach. By including the operating and disposal costs, the principle of sustainability is applied. However, the LCC approach is also applied in the real estate economy.
Most companies using life cycle costing are large manufacturers of products in the automotive, electrical and electronics industries (1996: 67 percent, 2001: 71 percent). The degree of adoption of Life Cycle Costing of 28 percent is very low compared to other cost control concepts. More than half of the companies that do not use Life Cycle Costing justified the concept of Life Cycle Costing as inappropriate and/or too expensive, according to research.
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