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Understanding TCO (Total Cost of Ownership): Origins, definition, calculation, advantages, and so on

TCO
October 2nd, 2018
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TCO (Total Cost of Ownership*) is a calculation method that determines the overall cost of a product or service throughout its life cycle. This method combines both direct and indirect costs.

In this post, you will find the answers to all of your TCO questions:

The origins of TCO

Some experts claim that the Total Cost of Ownership concept dates back to the Napoleonic era, when engineers would try to assess the efficiency of their cannons by analysing their service life and any repairs required, among other factors.

One thing is certain: The Total Cost of Ownership approach was formalised by the US Department of Defense, which wanted to assess the total costs associated with a defence programme. This project resulted in the publication of a military standard in the late 1990s.

Since then, this method has been used by companies, especially in the industrial sector, to calculate the cost of production and thus determine their margins and sales prices.

What is 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, who worked as an analyst at Gartner as the concept was first gaining ground, 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.

How to calculate TCO

Various models are available to calculate the Total Cost of Ownership, depending on the product or service in question (computing solutions, vehicle fleets etc.)

"There is no global solution for determining TCO in all purchasing departments. For truly relevant solutions, it is much better to consider the specifics of each activity sector", explained Didier Sallé, President of the French National Procurement Council (CNA) in the Île-de-France region, during a purchasing expertise event (Jeudis de l'Expertise Achats).

Total Cost of Ownership normally includes eight key elements:

  • Purchase price: cost price and supplier margin.
  • Associated costs: transport, packaging, customs duties, payment terms etc.
  • Acquisition cost: operation of the purchasing department.
  • Cost of ownership: stock management, depreciation costs etc.
  • Maintenance costs: spare parts, maintenance etc.
  • Usage costs: use value, operation, services etc.
  • Non-quality costs: deadline compliance, non-compliance processes etc.
  • Disposal costs: recycling, resale, disposal etc.

TCO remains a purely economic approach. Fifteen years ago, Gartner created a new methodology, known as Total Value of Ownership. This concept encourages companies to look beyond cost as the main driving force behind decisions, and to include other benefits such as growth and sustainability, in addition to risk management and reduction. This calculation model is similar to TCO, but includes additional and non-monetary benefits.

TCO: The benefits

Reducing Total Cost of Ownership remains one of the most popular strategies among procurement decision makers (32% of companies) in order to create value[1], and can offer many benefits:

  • Grounds for negotiation with suppliers.
  • Guidance tool for optimising direct or indirect costs (avoiding waste, exceeding quality requirements etc.).
  • Decision-making aid for outsourcing/internalisation operations etc.
  • ROI (Return on Investment) or ROTI (Return on Time Investment) evaluation.
  • Improved long-term financial performance.

 

 

[1] Deloitte

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