What are the components of TCO?

Updated on June 2nd, 2022
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TCO (Total Cost of Ownership) is the overall cost of a product or service throughout its life cycle. This calculation method takes into account both direct and indirect costs. Knowing this total cost of ownership provides an additional opportunity for value creation. A powerful decision-making aid, TCO calculation paves the way for expense optimisation. In this article, you’ll find all the information to answer your questions about TCO: where does it come from? What is its definition? How do you calculate it? What benefits does it bring?

Where does TCO come from?

Some experts claim that the concept of TCO dates back to the early 19th century, when engineers would try to assess the efficiency of their cannons by conducting an analysis of their service life and any repairs required, for instance.

One thing is certain: the TCO approach was formalised by the US Department of Defence with a view to assessing the overall costs associated with a defence programme. This project resulted in the publication of a military standard in the late 1990s.

Since then, the Total Cost of Ownership method has been used by companies, particularly in the industrial sector, to more accurately calculate the cost of production and thus better determine their margins and sales prices.

What is the definition of TCO?

TCO (Total Cost of Ownership) aims to analyse the actual cost of purchasing a product or service from a given supplier, beyond the basic purchase price.

Bill Kirwin, an analyst at Gartner, an American consulting and research company, is credited with creating the concept. He defines TCO as “the total cost of acquiring, using, managing and withdrawing an asset over its entire life cycle”.

In this sense, TCO brings together all of the costs associated with a particular product or service throughout its life cycle, not only considering direct costs, but also indirect costs, also known as “hidden” costs.

To determine the TCO of a product or service, you need to know how to calculate it.

How do you calculate TCO?

TCO can be calculated in several ways depending on the type of product or service concerned (software solutions, car fleets, etc.).

“There is no absolute solution for determining TCO in all procurement departments. For truly relevant solutions, it is much better to consider the specifics of each line of business,” explains Didier Sallé, President of the French National Procurement Council.

What are the components of TCO? The Total Cost of Ownership is generally calculated as the sum of these 8 types of costs:

  1. Purchase price: cost price and supplier margin;
  2. Cost incurred: transport, packaging, customs duties, payment terms;
  3. Cost of acquisition: procurement department operations;
  4. Cost of ownership: stock management, depreciation cost;
  5. Cost of maintenance: spare parts, servicing;
  6. Cost of usage: use value, operation, services;
  7. Cost of poor quality: deadline compliance, non-compliance processes;
  8. Cost of disposal: recycling, resale, destruction.

Take the example of the ownership of one or more company cars. The TCO calculation takes into account the various elements listed above. The cost incurred includes transport costs and customs duties, for instance.

The use and ownership of this type of vehicle is subject to taxes, which are also included in the TCO calculation. These may vary from country to country. The TCO also takes into account registration costs, as well as potential environmental bonuses or penalties.

This means that a careful calculation must be made between the costs incurred and the benefits reaped from owning company cars.

To go further, Gartner has been using a new methodology for the last fifteen years: the Total Value of Ownership. This concept encourages companies to look beyond costs as the main decision criterion and to consider the beneficial returns of a purchase (growth, risk control, sustainability, etc.). This calculation model is comparable to TCO, which also includes additional, non-monetary benefits.

How can you reduce your TCO and what are the benefits?

Reducing the Total Cost of Ownership is one of the most popular strategic levers used by procurement decision makers to create value[1] (favoured by 32% of decision makers). This cost reduction is achieved firstly by calculating the TCO, which takes into account the elements mentioned above.

Once the results have been calculated, it is time for optimisation. For a company vehicle, the reduction in TCO can relate to maintenance costs and the implementation of best practices to minimise fuel consumption and wear and tear on the vehicle.

There are many benefits to TCO:

  • Management tool for optimising direct or indirect costs (avoid waste, excess quality, etc.);
  • Bargaining point for supplier negotiations; Assessment of ROI (Return on Investment) or ROTI (Return on Time Investment) with monitoring of relevant KPIs;
  • Decision-making support for outsourcing and insourcing operations, etc.;
  • Improved long-term financial performance.

Training on TCO calculation can be offered to procurement decision makers to improve the company’s profitability.

This system has proved its worth. Calculating your Total Cost of Ownership ensures that the most effective levers are used and that the company’s TCO is considerably reduced for more efficient financial management.

[1] Source: Deloitte

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