A Comparative Analysis of the Total Cost of Ownership Approach in Sourcing Decisions

Table of Contents

1. Introduction

2. Comparing Cost-based Models for management decision making
2.1 TCO: an overview
2.2 Investigating the purchase price: an analysis of supplier costs
2.3 Target Costing – an end customer-oriented way of costing
2.4 Cost Model Synopsis

3. TCO in strategic purchasing

4. Conclusion

References

Bibliography

1. Introduction

As a result of globalisation, ^[1]increased competitive pressures, concentration on core competencies and the resulting outsourcing trend, the importance of companies’ procurement function has increased strongly (e.g. van Weele 2010; Moser 2007; Beissel 2003). The purchasing department is now involved in long-term decisions, such as selecting key suppliers or deciding on make-or-buy of materials and services (including outsourcing of internal functions) (De Boer et al. 1998). It became more and more obvious that the purchase price (of a good or service^[2] ) alone is no longer sufficient to take this decision, as often, many additional costs incur (e.g. Reve 2002; Ellram / Siferd 1993). An approach that tries to consider these additional costs related to a purchase is the “Total Cost of Ownership” (TCO) approach.^[3]

This paper introduces the TCO concept and compares it with other common cost models for management decisions. Subsequently, the initial statement on supplier selection is further discussed with a view on the findings of the cost model analysis. The paper closes with a short summary. As the basis for this work, a wide range of academic literature was used deductively in order to frame the discussion.

2. Comparing Cost-based Models for management decision making

2.1 TCO: an overview

As previously mentioned, TCO aims at providing a longer term perspective on the costs associated with the purchase of a good (Ellram / Siferd 1993; Ferrin / Plank 2002). In times where procurement was mainly a clerical function, products simply had to be purchased at the right price, time and quality (Pearson / Gritzenmacher 1990; Humphreys et al. 2000). Nowadays, where procurement is more and more involved in strategic decisions, a more long-term perspective on what resources a company commits when procuring a good is needed (Ferrin / Plank 2002). The idea of TCO therefore is to evaluate the costs that are involved in preparing and conducting the purchase as well as that occur during the lifecycle of the product (Ellram / Siferd 1993).^[4] In the case of a machine for example,^[5] pre-transaction costs could be supply market research or supplier negotiations; actual transaction costs consider more obvious elements as the purchase price, but also might assign a value to less visible costs such as payment terms (which might cause the need to refinance the purchase price and incur e.g. interest); post transaction costs consider the costs that occur during the lifecycle of the machine, e.g. maintenance costs or energy consumption of the machine (Ellram 1993; Boge, 2008). Moreover, even qualitative aspects could be taken into consideration by quantifying them, e.g. by assigning a monetary value to the impact of the purchased good on the satisfaction of the buyer’s customer (Ellram / Maltz 1995). The table on the following page provides an overview of potential elements to be considered in TCO evaluations. However these are just general suggestions. Additional elements can and should be integrated where required (Ellram 1993).

illustration not visible in this excerpt

Figure 1: Major Categories for the Components of Total Cost of Ownership (Source: Ellram 1993, p.7, slightly modified; Boger 2008)

The idea behind this is relatively clear: going for the lowest price in the first place could be easily outweighed by the total of costs that occur once the product is in use: a low-priced machine could incur a multiple of its purchase price in maintenance and repair costs as well as energy costs for running the machine (Dance et al. 1996). A machine that costs more at the time of purchase, but can be run more efficiently afterwards, may be the better choice. The key use of TCO therefore is to provide a basis for supplier selection and/ or evaluation (e.g. Ellram 1993; Ellram 1995; Ferrin / Plank 2002).

The use of TCO is beneficial to a number of management aspects. First of all, it improves decision making by considering a broader basis of impacting (cost) factors (Ellram 1994). With that comes the need to assign a value to qualitative factors, which facilitates trade-offs between decision alternatives, but replaces “gut feeling” with a comprehensive method of evaluating and ranking these alternatives (Ellram 1994). Yet by considering a wide number of criteria, the quality of the decision is still much more balanced than if just focusing on price as the single criterion (Dulmin / Minnino 2003; Bevilacqua / Petroni 2002). This is even more valid when comparisons of complex products (i.e. product-service combined solutions) have to be made (Oliva / Kallenberg 2003); supplier negotiations could be facilitated by directing the discussion on the TCO and thus the long-term value of a purchase. In short: comparisons of where and from whom to source are improved (Ellram / Siferd 1998). For the case of sourcing internationally for example, a TCO analysis considering aspects such as delivery costs (incl. duties/ tariffs), supply risk (e.g. longer lead times) or quality risk (e.g. by signing unknown suppliers) could reveal that the actual “total costs” for sourcing internationally are much less favourable than if looking at the initial purchase price (Krokowski 1998).

However, the application of TCO is subject to some limitations that should be considered. First of all, using TCO requires skilled and experienced resources. Moreover, sufficient (reliable) data needs to be available to be used in such a model (Ellram 1994). The more complex the good to be purchased, the more difficult it might become to obtain this data. If it is not available or cost information is largely based on assumptions, this could lead to decision bias: cost assumptions could be taken to favour or disadvantage certain supplier (Degraeve et al. 2000; Smytka / Clemens 1993). Related to this is a typical risk of quantifying qualitative aspects: people tend to take “numbers” for granted (Porter 1996), although in TCO, sometimes assumptions are taken to allow quantification of qualitative data (Ellram / Sifer 1998). In addition, defining the scope of the TCO analysis and conducting it accordingly can be a time consuming task, e.g. for setting up a model or collecting the data (Zachariassen / Arlbjørn 2011). This becomes even more critical, as “one TCO model does not fit all”, thus needs to be customized to the good in focus (Ellram 1995). Another limitation of TCO becomes apparent when the perspective of the analysis is broadened towards the up- and downstream of the supply chain: considering the actual costs of the supplier and the customers’ willingness to pay a certain price for a company’s product. Both of these perspectives are now discussed in brief.

2.2 Investigating the purchase price: an analysis of supplier costs

The purchase price is usually considered as it was quoted by the supplier(s) (Ellram 1993). Although it can be reduced e.g. in negotiations, the TCO concept does not question how the price is actually composed. It is this issue that is in focus of “supplier cost analysis” (Newman 1992). The idea is to analyse the purchase price and split it up into cost groups that incur at the supplier (e.g. material-, production-, overhead or distribution cost). By doing so, the understanding for the suppliers’ challenges is improved, but also areas for improvement can be identified (van Weele 2010). Concerning the first aspect, knowing the cost drivers of the supplier could lead the buyer to align his expectations (Anklesaria 2008).^[6] Looking at its cost structures may secondly also lead to discussions with the supplier to reduce some of its costs as a result of benchmarking its cost structure with other companies (Monczka et al. 2008). Last but not least, cost structure analysis can also help to identify the margin a supplier is charging. The reduction of this margin can be an important point for supplier negotiations (van Weele 2010).

However, not surprisingly, suppliers are sometimes reluctant to share this kind of data, requiring the buyer to derive his own assumptions (e.g. by using industrywide or competitor-based data) (Monczka et al. 2008). This again would distort the usefulness of the data to some extent. Nonetheless, suppler cost analysis would provide an enhancement to the TCO analysis (and respective supplier selection decisions) by extending the analytical scope to the upstream supply costs (Linn et al. 2006). In addition, it could provide an estimate how expensive a purchased good might be - before a request for quotation or similar is sent to potential suppliers.

[...]

^[1] Although the assignment brief suggests an essay format, some formal structure has been integrated to facilitate the reader’s understanding of the discussion. The Table of Contents is provided for the same reason.

^[2] Whereas key differences between goods/material and services purchasing exist (e.g. Wynstra et al. 2006; Smeltzer / Ogden 2002), these terms shall be used interchangeably for the course of this paper and only differentiated where specifically necessary

^[3] Please see 2.1 for a more detailed discussion

^[4] A similar concept to TCO is Life cycle costing (LCC); it was considered as one of the comparative cost models, however, as the similarities to TCO are high and some authors even argue that TCO and LCC are basically the same, it was decided to select more differentiated cost models for comparison (Ellram 1995).

^[5] TCO is by some authors limited to purchases of capital equipment; however, contrary opinions exist, claiming that TCO is practically possible (but not necessarily sensible) for any good or even services

^[6] One typical example is the service responsiveness expecations of the buyer. Very often, these are specified very narrow although this may not be needed (e.g. 24 hours service). Knowing how much keeping this up costs the supplier might lead the supplier to reduce his demands and thus save costs for both parties (Boge 2008).